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Government Sponsorship of the 

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The United States Department of the Treasury 



July 11, 1996 



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Government Sponsorship of the 

Federal National Mortgage Association and the 

Federal Home Loan Mortgage Corporation 



IKEASURY DEPARTMENr LIBRARY 




LIBRARY 
ROOIVI 5030 

DEC 09 1996 



ASURY DEPARTMENT. 



The United States Department of the Treasury 



July 11, 1996 



For sale by the U.S. GovemmenI Printing Office 

Superintendent of Documents. Mail Stop: SSOP. Washington, DC 20402-9328 

ISBN 0-16-048725-0 




THE DEPUTY SECRETARY OF THE TREASURY 

WASHINGTON 

July 11, 1996 



The Honorable Alfonse M. D'Amato 

Chairman 

Committee on Banking, Housing, 

and Urban Affairs 
U.S. Senate 
Washington, D.C. 20510-6075 

Dear Mr. Chairman: 

I am pleased to transmit the Department of the Treasury's report on the Federal National 
Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation 
(Freddie Mac). 

As required by section 1355 of the Federal Housing Enterprises Financial Safety and 
Soundness Act of 1992, this report examines the desirability and feasibility of ending the 
federal government's sponsorship of Fannie Mae and Freddie Mac. Pursuant to this 
statutory mandate, we have conducted a broad review of the government's relationship with 
the two enterprises. We examined the benefits and constraints of government sponsorship, 
the enterprises' public purpose, and the effects of maintaining or amending the existing 
relationship between the enterprises and the federal government. The Department of 
Housing and Urban Development, the Congressional Budget Office, and the General 
Accounting Office have also conducted studies pursuant to the Act. 

As a result of over three generations of U.S. government policy supporting 
homeownership, the United States now has the strongest housing finance market in the 
world. Today, homeownership rates in the U.S. are at their highest levels in sixteen years. 
Fannie Mae and Freddie Mac have played critical roles in building a hquid secondary 
market for home mortgages, thereby helping make homeownership possible for millions of 
Americans. Through their affordable housing activities, they have also contributed to 
expanding homebuying opportunities for low- and moderate-income families. 

We believe that firm conclusions regarding the desirability of ending or modifying the 
government's sponsorship of Fannie Mae and Freddie Mac are premature. Considerable 
uncertainty exists on an array of important issues. For example, it is still too early to assess 
the efficacy of various provisions of the 1992 Act, notably including the affordable housing 
goals applicable to the two enterprises, and the new system of safety and soundness 
regulation. Moreover, attempting to quantify the benefits and costs of government 



retain a substantial portion of the benefits of their government subsidy. These and other 
issues would benefit substantially from further study aimed at helping policymakers better 
understand the benefits and costs of continued federal government sponsorship both to the 
public and to the enterprises. 

Fannie Mae and Freddie Mac are important institutions participating in markets that affect 
millions of Americans. Ultimately, any change in their status will require a rigorous public 
discussion and a broad consensus. We hope this report is a helpful contribution to that 
process. 

Sincerely, 




Lawrence Summers 
Deputy Secretary 



Enclosure 




THE DEPUTY SECRETARY OF THE TREASURY 

WASHINGTON 

July 11, 1996 



The Honorable James A. Leach 

Chairman 

Committee on Banking and Financial Services 

U.S. House of Representatives 

Washington, D.C. 20515-6050 

Dear Mr. Chairman: 

I am pleased to transmit the Department of the Treasury's report on the Federal National 
Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation 
(Freddie Mac). 

As required by section 1355 of the Federal Housing Enterprises Financial Safety and 
Soundness Act of 1992, this report examines the desirabihty and feasibility of ending the 
federal government's sponsorship of Fannie Mae and Freddie Mac. Pursuant to this 
statutory mandate, we have conducted a broad review of the government's relationship with 
the two enterprises. We examined the benefits and constraints of government sponsorship, 
the enterprises' pubhc purpose, and the effects of maintaining or amending the existing 
relationship between the enterprises and the federal government. The Department of 
Housing and Urban Development, the Congressional Budget Office, and the General 
Accounting Office have also conducted studies pursuant to the Act. 

As a result of over three generations of U.S. government policy supporting 
homeownership, the United States now has the strongest housing finance market in the 
world. Today, homeownership rates in the U.S. are at their highest levels in sixteen years. 
Fannie Mae and Freddie Mac have played critical roles in building a Uquid secondary 
market for home mortgages, thereby helping make homeownership possible for millions of 
Americans. Through their affordable housing activities, they have also contributed to 
expanding homebuying opportunities for low- and moderate-income families. 

We believe that firm conclusions regarding the desirabihty of ending or modifying the 
government's sponsorship of Fannie Mae and Freddie Mac are premature. Considerable 
uncertainty exists on an array of important issues. For example, it is still too early to assess 
the efficacy of various provisions of the 1992 Act, notably including the affordable housing 
goals applicable to the two enterprises, and the new system of safety and soundness 
regulation. Moreover, attempting to quantify the benefits and costs of government 
sponsorship is inherently difficult and imprecise. Our report estimates that the two GSEs 



retain a substantial portion of the benefits of their government subsidy. These and other 
issues would benefit substantially from further study aimed at helping policymakers better 
understand the benefits and costs of continued federal government sponsorship both to the 
public and to the enterprises. 

Fannie Mae and Freddie Mac are important institutions participating in markets that affect 
miUions of Americans. Ultimately, any change in their status will require a rigorous public 
discussion and a broad consensus. We hope this report is a helpful contribution to that 
process. 

Sincerely, 



7-^ 




Lawrence Summers 
Deputy Secretary 



Enclosure 



TABLE OF CONTENTS 

SUMMARY 1 

INTRODUCTION 13 

I. FANNIE MAE, FREDDIE MAC, AND THE HOUSING CREDIT MARKET ... 17 

A. The Creation and Evolution of Fannie Mae And Freddie Mac: 

A Historical Overview 17 

B. Secondary Mortgage Market Operations of Fannie Mae and 

Freddie Mac 20 

C. Summary 23 

II. GOVERNMENT SPONSORSHIP OF FANNIE MAE AND FREDDIE MAC ... 25 

A. Benefits AND Constraints OF Government Sponsorship 25 

1. Benefits of Government Sponsorship 25 

2. Constraints of Government Sponsorship 28 

B. Estimating THE Value OF Government Sponsorship 29 

1 . Benefits Related to Securitizing Mortgages 29 

2. Benefits Related to Retaining Mortgages in Portfolio 31 

3. Benefits That Reduce the GSEs' Operating Costs 33 

4. Estimating the Gross and Net Value of Government Sponsorship ... 34 

C. The GSEs' Current Business Operations and Profitability 36 

1 . Mortgages Outstanding 36 

2. Sources of Income, and Growth of Retained Portfolio 37 

3. The Profitability of Fannie Mae and Freddie Mac 40 

D. Summary 41 



u 

III. THE GSES' PUBLIC PURPOSE 43 

A. The Current Structure of the Housing Finance Market 43 

B. System-Wide Imperfections in the Housing Finance Market 45 

1. The Capability of the Private Sector Secondary Market 45 

2. Withstanding Tight Credit Markets 51 

3. Weathering Regional Economic Downturns 53 

C. Affordable Housing Needs 54 

1. The GSEs' Achievement of HUD's Affordable Housing Goals ....54 

2. Affordable Housing Achievements: The GSEs Relative to the 

Market 58 

a. Share of Business from Targeted Borrower Groups 58 

b. Share of Overall Market Serving Targeted Borrower 

Groups 63 

D. Summary 67 

IV. POTENTIAL EFFECTS OF ENDING GOVERNMENT SPONSORSHIP AND 

OF MAINTAINING THE STATUS QUO 69 

A. Risks of Ending Government Sponsorship 69 

1. Effect on the Liquidity and Stability of the Mortgage Market 69 

2. Effect on Mortgage Interest Rates 70 

3. Effect on Affordable Housing Efforts 75 

B. Risks of Maintaining THE 5x471/5 gco 77 

1. Effect on Treasury Borrowing Costs 77 

2. Effect on Other Credit Markets 78 



HI 

3. Potential for Increased Reliance on the GSEs 78 

4. Effect on Potential Risk to the Taxpayer 79 

5. The Tension Between Profit and Public Purpose 81 

C. Balancing the GSEs' Public Purpose and the Benefits of 
Government Sponsorship 81 

D. Summary 83 

BIBLIOGRAPHY 85 



IV 

LIST OF TABLES 

Table IL 1: Mortgages Securitized and Retained in Portfolio by Fannie Mae and 

Freddie Mac, 1989 to 1995 37 

Table n.2: Fannie Mae and Freddie Mac Percentages of Total Revenue by Sources 

of Income 38 

Table n.3: Increased Focus on Retained Portfolio by Fannie Mae and Freddie Mac ... 39 

Table IT. 4: Comparisons of After-Tax Return on Equity 41 

Table III. 1: Distribution of Single-Family Mortgage Loan Originations, 1994 44 

Table III. 2: Comparison of Mortgage-Backed Securities Issued and Securitization 

Rates for Conforming and Jumbo Mortgages 47 

Table III. 3: Share of Home Mortgage, Revolving Credit, Automobile, and 

Commercial Real Estate Debt Securitized 50 

Table III. 4: Size of Home Mortgage Market Relative to Other Financial Markets 52 

Table III. 5: Overview of the GSEs' Affordable Housing Goals and Performance 56 

Table III. 6: Percentage of Secondary Market Participants' Loan Purchases From 

Targeted Borrower Groups 59 

Table III. 7: Relative Share of Targeted Borrower Loans in the Credit Risk Portfolios 

of Mortgage Market Participants, 1994 (FHA-eligible loan size category) . . 62 

Table ni.8: Summary of the Overall Allocation of the Credit Risk Associated with 
Lending to Targeted Borrower Groups, 1994 (FHA-eligible loan size 
category) 64 

Table III. 9: Distribution of Borrower and Census Tract Characteristics of FHA and 

GSE Home Purchase Mortgages in Metropolitan Areas, 1993 66 

Table TV. 1: National Averages on Fixed-Rate Mortgages 71 

Table IV. 2: Estimated Differences in Rates Between Jumbo Loans and Conforming 

Loans By Lender, 1989-1993 73 



LIST OF FIGURES 



Figure 1. 1: Secondary Market Operations of Fannie Mae and Freddie Mac 21 

Figure III. 1: Share of Total Non-Conforming and B-C Credit Closed-End (Fixed 

Amortization Schedule) Mortgage Originations Securitized 48 

Figure IV. 1: Quarterly Changes in Average Mortgage Rates 74 



SUMMARY 



Created by Congress to provide stability and liquidity to the secondary mortgage 
market, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan 
Mortgage Corporation (Freddie Mac) are privately owned companies known as 
government-sponsored enterprises (GSEs). Like other GSEs', Fannie Mae and Freddie Mac 
have corporate charters granted by the federal government. To promote a public purpose, 
those charters limit Fannie Mae and Freddie Mac to a particular line of business - operating in 
the secondary mortgage market -- and provide various government benefits that lower their 
operating costs and enable them to borrow at rates much lower than other financial institutions. 

As a result of over three generations of U.S. government policy supporting 
homeownership, the United States now has the strongest housing finance market in the world. 
To make housing available to more Americans, Congress made an explicit judgment to direct 
credit toward home mortgages. One way it sought to do so was by creating intermediaries 
such as Fannie Mae and Freddie Mac that would buy and resell mortgages. Fannie Mae and 
Freddie Mac have played critical roles in building a liquid secondary market for home 
mortgages. This system has helped make homeownership possible for millions. 

Despite this enormous progress, many low- and moderate-income and minority families 
continue to face substantial barriers to homeownership. President Clinton has made increased 
homeownership a national priority, and with the help of his National Homeownership Strategy, 
the homeownership rate has reached 65.1 percent this year, the highest level in fifteen years. 
Both GSEs have made, and continue to make, important contributions toward meeting the 
national goal of increased homeownership. 

Fannie Mae and Freddie Mac are privately owned. Their stock trades actively on the 
New York Stock Exchange, and had a total market value of over $48.7 billion at the end of 
1995. Last year they paid a total of $957 million in common stock dividends. As a result, in 
part, of their government sponsorship, Fannie Mae and Freddie Mac can participate in the 
mortgage market at lower costs and in ways that other private financial institutions cannot. 
Clearly Fannie Mae and Freddie Mac must serve their shareholders, but they must also comply 
with their federal charters. This ambiguity of responsibility, characteristic of GSEs, 
continually raises issues of accountability: To what extent is a particular GSE responding to 
its federal mandate and to what extent to the need to generate returns for its stockholders? 
What tradeoffs does it make between these objectives? 

In the Federal Housing Enterprises Financial Safety and Soundness Act of 1992, 
Congress recognized these issues, and recognized that many of the circumstances that had led 



' The other GSEs include the Federal Home Loan Bank System, the Farm Credit System, the Student Loan 
Marketing Association, and the College Construction Loan Corporation. See U.S. Department of the 
Treasury (1990,1991) for more information on GSEs. 



to the establishment of Fannie Mae and Freddie Mac in their current forms had changed. The 
Act directed the Treasury Department and three other agencies^ to report on the desirability 
and feasibility of ending the federal government's sponsorship of Fannie Mae and Freddie 
Mac, and thereby removing both the limitations and benefits of federal sponsorship. If 
privatized, Fannie Mae and Freddie Mac could operate as fully private entities under state 
corporate charters. Their shareholders and management would determine the nature and scope 
of their business activities. 

In response to this mandate, the Treasury Department conducted a broad review of the 
government's relationship with Fannie Mae and Freddie Mac. We paid particular attention to 
how ending the federal government's sponsorship of Fannie Mae and Freddie Mac might affect 
the cost of home mortgage credit and the efficiency of the mortgage credit market. We also 
reviewed their affordable housing activities, to help assess whether and how these might be 
affected. 

The Secondary Mortgage Activities of Fannie Mae and Freddie Mac 

Fannie Mae and Freddie Mac operate by purchasing conforming residential mortgage 
loans — mortgages that meet their specifications and are below a certain size limit. The GSEs 
purchase these mortgages from banks, thrifts, mortgage banks, and other mortgage loan 
originators. By doing so, they give these originators access to the broader national capital 
market. 

Fannie Mae and Freddie Mac finance these purchases in two ways. First, they pool 
mortgages and issue securities backed by the pooled mortgages, in a process called 
securitization. Mortgage-backed securities represent interests in the underlying mortgages. 
The mortgage borrowers' monthly payments of interest and principal are used to pay investors. 
The GSEs guarantee these payments and, in return, collect a guarantee fee. Second, the GSEs 
purchase mortgages for their own portfolios, and fund them by issuing debt securities to 
investors. 

The Benefits of Federal Sponsorship 

Federal sponsorship helps Fannie Mae and Freddie Mac undertake their activities in 
several important ways. First, it reduces the GSEs' operating costs by: exempting them from 
paying state and local corporate income taxes; exempting their securities from registration with 
the Securities and Exchange Commission; and authorizing them to issue and transfer securities 
through the Federal Reserve's book-entry system. 



^ The other agencies are the U.S. Department of Housing & Urban Development, the Congressional 
Budget Office, and the General Accounting Office. Each has produced a separate analysis and report. 



Second, government sponsorship permits the GSEs to borrow at rates better than the 
highest-rated private firms -- and very close to the rates on Treasury securities, which carry 
the government's full faith and credit. In addition to giving the GSEs the advantages 
mentioned above, federal law gives special status to GSE securities. It permits national banks 
to hold them in unlimited amounts. It makes them lawful investments for federal fiduciary and 
public funds and lawful collateral for public deposits. It authorizes the Secretary of the 
Treasury to purchase up to $2.25 billion of each GSE's obligations (and thus extend credit to 
the GSE). In addition, GSE securities are eligible collateral for loans from Federal Reserve 
Banks and Federal Home Loan Banks, and the Federal Reserve buys and sells such securities 
in its open market operations. The federal government does not guarantee GSE securities -- in 
fact, federal law requires a disclaimer of any U.S. obligation. Investors nonetheless believe 
that federal sponsorship provides a de facto guarantee -- because they believe that Congress 
would not permit either GSE to fail. This perception, in turn, enables Fannie Mae and 
Freddie Mac to borrow at rates lower than any private financial institution. 

Third, the two GSEs hold less capital than comparable fully private firms, without 
incurring higher borrowing costs. At the end of 1995, the two GSEs had a combined $1.4 
trillion in mortgage-backed securities outstanding, mortgages in portfolio, and other assets, but 
only $16.8 billion in capital. The two GSEs had an average capital-to-assets ratio of 3.9 
percent. That ratio falls to 2.75 percent if one allocates capital, at the minimum rate currently 
required by the GSEs' safety and soundness regulator, to the $972 billion in mortgage-backed 
securities that the GSEs have guaranteed but do not carry on their balance sheets. By contrast, 
FDIC-insured savings institutions, which invest predominantly in mortgage-related assets, had 
an average capital-to-assets ratio of 7.8 percent. 

We estimate the benefits of federal sponsorship are worth almost $6 billion annually to 
Fannie Mae and Freddie Mac. Of this amount, reduced operating costs (i.e., exemption from 
SEC filing fees and from state and local income taxes) represent approximately $500 million 
annually and the borrowing cost advantage over $5 billion annually. These estimates are 
broadly consistent with the magnitudes estimated by the Congressional Budget Office and 
General Accounting Office. As we discuss below, Fannie Mae and Freddie Mac appear to 
pass through part of these benefits to consumers through reduced mortgage costs and retain 
part for their own stockholders. 

These three types of benefits aid Fannie Mae and Freddie Mac in both aspects of their 
business — securitizing mortgages and retaining mortgages in portfolio. The benefits currently 
involve no direct government payments to the two GSEs and under current rules are not 
reported in the federal budget. Nonetheless, they have real economic value to the GSEs and 
involve real costs for the government to provide, a conclusion readily accepted by economic 
and financial experts. While fully private firms frequently pay fees to third-party guarantors to 
provide credit enhancement for their securities, the GSEs receive at no cost to them a package 
of benefits that makes the credit standing of their securities superior to anything available in 
the marketplace. 



4 

The Contributions of Fannie Mae and Freddie Mac 

Providing Liquidity for Mortgage Lenders 

Congress created Fannie Mae as a government corporation in 1938 to purchase and 
resell mortgages, and thereby help provide liquidity to financial institutions that had limited 
access to national capital markets. Freddie Mac was created in 1970 with a similar purpose. 
Both organizations have, as intended, contributed strongly to the development of a more open, 
effective, and liquid mortgage market. 

Over the past 25 years, these two companies and the financial markets have changed 
dramatically. Interest rate ceilings have been eliminated and limitations on geographic 
expansion reduced. Mortgage lenders now have geographic diversification and access to 
national (and international) capital markets. 

One of the most important changes was the development of securitization itself. The 
first mortgage backed security was created in 1970 by the Government National Mortgage 
Association, Ginnie Mae. Since then, Ginnie Mae, Fannie Mae, and Freddie Mac have each 
contributed to the development of mortgage securitization. Today, approximately 48 percent 
of outstanding single-family mortgage debt -- over $1.7 trillion — has been pooled and 
securitized. Mortgages securitized by Fannie Mae and Freddie Mac represent approximately 
62 percent of the dollar total. 

This activity is no longer limited to GSEs or to government organizations like Ginnie 
Mae; private companies securitized 46 percent of jumbo mortgages in 1994, a rate comparable 
to the 52 percent of conforming mortgages securitized by Fannie Mae and Freddie Mac. 
Private companies have also begun a secondary market in mortgages with substandard credit 
quality (commonly called B-C credit mortgages), as well as auto loans, credit card loans, and a 
variety of other obligations. 

Despite the development of private liquid secondary markets, ending the GSEs' federal 
sponsorship would probably cause an increase in home mortgage rates for conforming, 
conventional loans (as discussed below). Although the amount of any such increase is difficult 
to determine, it should be smaller than the fluctuations in mortgage rates attributable to normal 
variations in macroeconomic and credit market factors. 

Savings on Mortgage Costs 

One question is the extent to which Fannie Mae and Freddie Mac pass on the fruits of 
government sponsorship to consumers in the form of reduced mortgage costs. The GSEs can 
pass through those benefits by purchasing mortgages at higher prices (lower mortgage rates) 
than they would without government sponsorship. Such a pass-through is inherently difficult 



to measure. In preparing this report, we sponsored one study of this issue and reviewed 
others. 

Most discussions of pass-through focus on the differences between the market rates for 
the fixed-rate conforming mortgages that Fannie Mae and Freddie Mac can and do purchase, 
compared to non-conforming mortgages (generally larger jumbo mortgages) that can be 
purchased only by other private financial institutions. Some comparisons have been made 
based upon the advertised on-offer rates for the two types of mortgages. These comparisons 
typically show a rate advantage for conforming mortgages. Other studies have compared the 
Federal Housing Finance Board's data on mortgages that actually have closed and have found 
average rates on jumbo loans lower than on conforming loans. 

However, raw comparisons may mislead, because other factors could affect the price 
differential between conforming and jumbo loans; the size and terms of the mortgages, their 
geographic location and credit quality, or the depth and liquidity of the market for larger 
versus smaller homes may have independent effects. After attempting to control for some of 
these factors statistically, recent studies suggest that the GSEs reduce interest rates on 
fixed-rate conforming, conventional mortgages by roughly 20 to 40 basis points. It is unclear 
how much of such a differential results from pass-through of GSE benefits rather than from 
such other factors as the GSEs' technical and managerial efficiency; furthermore, the 
differential may change over time. A plausible estimate of 30 basis points, the midpoint of 
this range, suggests that in 1995 the GSEs passed through approximately $4 billion of pre-tax 
benefits. 

This calculation necessarily omits certain factors. It does not include the value of the 
stability the GSEs may give the conforming, conventional mortgage market. Nor does it place 
a value on the extent to which the GSEs make affordable housing finance more available than 
it otherwise would be (an issue discussed below). 

It is even more difficult to estimate with certainty how modifying or ending 
government sponsorship would affect mortgage interest rates. Although some increase seems 
likely, certain factors suggest that the increase in rates might be less than the pass-through 
estimate given above. Fannie Mae and Freddie Mac currently have no effective competition in 
the conforming, conventional secondary mortgage market except each other. Nonetheless, 
many financial institutions compete vigorously in other secondary markets, for both mortgages 
and other types of obligations. Depending upon how changes were undertaken, competition 
from other financial institutions could moderate the effects of privatization. These issues have, 
however, received very little analysis; further research is necessary before definitive 
conclusions can be drawn. 



Suppotiing Affordable Housing 

Last year, the Department of Housing and Urban Development (HUD) released the 
Administration's blueprint for increasing homeownership, the National Homeownership 
Strategy: Partners in the American Dream. Many of the nation's critical unmet housing needs 
today differ from those of the past. Mortgages are now widely available, and so the 
Administration and Congress have focused on the needs of borrowers who continue to find 
homeownership beyond their grasp. The Homeownership Strategy outlines a series of steps 
that the public and private sectors should take to increase homeownership opportunities for all 
Americans. 

Both Fannie Mae and Freddie Mac have expanded their activities in these areas. They 
have developed specialized mortgage products, increased underwriting flexibility, improved 
homebuyer education programs, and entered into partnerships with local governments and 
nonprofit organizations to provide additional affordable housing assistance. 

In 1992, Congress directed HUD to develop a set of housing goals to ensure that the 
GSEs' mortgage purchases included loans to such targeted potential borrowers as low-income 
households and residents of central cities and rural areas. HUD issued interim requirements in 
October 1993. The final regulations, issued in December 1995, established targets for the 
GSEs' purchases of mortgages from underserved areas, low- and moderate-income households, 
and very-low-income households. The final regulation also established fair lending 
requirements, including a requirement that the GSEs assess whether their underwriting 
standards, business practices, repurchase requirements, pricing, fees, and procedures may 
result in impermissible discrimination, and how such standards and practices may affect 
purchases of mortgages for low- and moderate-income families. 

Fannie Mae and Freddie Mac already meet or exceed HUD's affordable housing goals 
in most respects. In 1995, Fannie Mae satisfied all three interim housing goals, and Freddie 
Mac satisfied all but the central city goal. Still, under a variety of measures, the GSEs' 
relative participation in financing affordable housing is less than that of FHA and FDIC- 
insured depository institutions. 

By the nature of their activities, Fannie Mae and Freddie Mac face challenges relative 
to other market participants in promoting affordable housing. They do not themselves make 
any direct loans; they must rely on others to originate loans that they may then purchase or 
help securitize. Current law permits them to purchase mortgages with less than a 20 percent 
downpayment only if the borrower obtains private mortgage insurance or if the private sector 
or a government agency provides some other credit enhancement that limits the GSEs' credit 
risk. 

There is continuing innovation in the primary market (i.e., the market for originating 
mortgages) and by private mortgage market participants, such as private mortgage insurance 



companies, finance companies, and FDIC-insured depository institutions. Fannie Mae and 
Freddie Mac can and do contribute to overcoming their challenges in this area by working 
cooperatively with mortgage originators and mortgage insurance companies to develop 
mortgage products for the underserved. 

Since 1992, Fannie Mae and Freddie Mac have increased their holdings of mortgages 
from low-income borrowers and underserved areas. For example, Fannie Mae, which has 
most strongly emphasized lending in inner-city neighborhoods, increased its activity in 
underserved areas (as defined in HUD's 1995 final rule on GSE housing goals) from 22.9 
percent in 1993 to 31.2 percent in 1995, while Freddie Mac's activity increased from 21.3 
percent to 25. 1 percent during the same period. Although this improved performance 
obviously results in part from HUD's oversight and encouragement, it is not possible to 
ascertain the extent to which it represents a response to that oversight, to the affordable 
housing activities of mortgage originators, or to diversification of the GSEs' business activities 
as their basic market becomes more saturated. For example, the majority of single-family 
mortgages that counted toward meeting the HUD goals in 1995 (64 percent or more for each 
goal and each GSE) went to borrowers who made downpayments of at least 20 percent. Since 
a lack of funds for downpayments constitutes one of the main impediments to homeownership 
in lower-income communities, it is unclear to what extent the goals have stimulated mortgage 
originators to make loans that they would not otherwise have made. However, affordable 
housing loans often entail higher marketing, servicing, and credit costs than other 
GSE-purchased loans, so these historical loan-to-value (LTV) ratios may understate the GSEs' 
effect on affordable housing. It is too early to evaluate fully whether a trend toward more 
flexible underwriting practices will increase the availability of higher LTV loans and spur 
additional mortgage originations to low- and moderate-income homebuyers. 

HUD reports that it designed the affordable housing goals to be achievable under 
economic conditions more adverse than the recent period of high affordability, and notes that 
they may become binding constraints as market conditions change. The goals may themselves 
be revised periodically to encourage the GSEs to increase their affordable housing activities 
beyond what the fully private sector might otherwise do. 

Ending government sponsorship would in all probability have some effect on the GSEs' 
contributions to affordable housing. Without being able to estimate the extent to which the 
GSEs undertake affordable housing activities because of federal requirements, rather than for 
other reasons, one cannot estimate how rescinding or revising HUD's goals would affect their 
activities. As HUD and the GSEs gain more experience with the goals, we should have better 
understanding of the effects of these programs. 

Expanding opportunities for homeownership should remain one of our highest 
priorities. The actions of GSEs and other financial institutions in this crucial area will merit 
continued attention from HUD and Congress. 



8 

Implications of the Status Quo 

Effect on Treasury Borrowing Costs 

Together, Fannie Mae and Freddie Mac have over $1.4 trillion in debt and 
mortgage-backed securities outstanding — an amount equal to nearly two-fifths of the Treasury 
securities held by the public. Since GSE securities may be substituted for Treasury securities 
for many purposes (as discussed above), and since they benefit from investors' perception that 
the federal government implicitly stands behind them, those securities compete directly with 
Treasury securities in the government securities market. To some extent, therefore, the 
considerable and growing supply of GSE securities (relative to the supply of Treasury 
securities) tends to lower prices in the government securities market and thereby increase the 
Treasury's borrowing costs. 

Nonetheless, it is extremely difficult to estimate by how much. Financial markets are 
both dynamic and complex; many factors affect their demand, supply, and segmentation. 
When the Treasury previously attempted (Treasury 1990, 1991) to estimate the effect of GSE 
borrowing on Treasury costs, it could not quantify those effects. These estimation difficulties 
remain; nonetheless, further analysis seems appropriate. Since the public holds $3.7 trillion of 
U.S. government debt, each basis point of increase in such costs would raise annual budgetary 
outlays by $370 million. 

Effect on Other Credit Markets 

While the benefits of GSE status provide an important subsidy that promotes 
homeownership, such a subsidy has economic costs. To the extent that the GSEs pass through 
the benefits of government sponsorship, they reduce the price of, and increase the demand for, 
mortgage credit relative to other types of credit. The economic effect of the subsidy to 
mortgage credit — absent increases in the savings pool or attracting capital from abroad - is to 
raise the price or reduce the amount of credit for other uses, such as small businesses, 
exporters, rural communities, and other business and consumer borrowers. Measuring such 
effects is, however, even more difficult than measuring the potential effects on Treasury 
borrowing costs. 

Potential for Increased Reliance on the GSEs 

Maintaining the current GSE status of Fannie Mae and Freddie Mac could, over time, 
find the housing finance market increasingly reliant on the GSEs as sources of credit for 
conforming, conventional mortgages. This increased reliance, coupled with the advantages the 
GSEs receive from government sponsorship, could undermine the viability of portfolio lenders 
operating in local markets, such as community banks and thrift institutions. If that were to 
occur, borrowers who do not easily meet the GSEs' underwriting standards may lose 
competitive local mortgage sources that may serve their needs better than national lenders. 



In addition, greater reliance on the GSEs could increase risk to financial markets and 
taxpayers by further concentrating mortgage credit risk in just two companies - companies 
with relatively low capital-to-asset ratios, whose GSE status alters investors' risk-reward 
calculus. 

Potential Risk to Taxpayers 

Although Fannie Mae and Freddie Mac have developed a range of mechanisms to 
hedge the risks of their portfolios and protect their financial integrity against movements in the 
financial markets, there is no perfect guarantee that they will always be safe, sound, and 
profitable entities. Recognizing this. Congress recently established HUD's Office of Federal 
Housing Enterprise Oversight (OFHEO) as the two GSEs' federal safety and soundness 
regulator. OFHEO' s establishment is a positive development that we expect to have a salutary 
effect on the two GSEs' safety and soundness. Such regulation is necessary, in part because 
the very nature of government sponsorship attenuates the normal market discipline that 
investors would otherwise exercise in purchasing securities issued by a fully private firm. 

OFHEO's mission is unquestionably important. Overseeing the GSE's safety and 
soundness diminishes the likelihood of financial difficulties that could raise any question of 
government assistance. The stringency and effectiveness of OFHEO's regulatory policies will 
therefore be critical. 

Further Analysis Required 

As noted above, further analysis of many of these issues is necessary for any informed 
conclusions. Research on both the current conforming mortgage market and the affordable 
housing market would help clarify both the risks and benefits of any action by Congress. 

There should also be detailed analysis of the operational and market implications of any 
particular action that Congress considers. If Congress decided to maintain the GSE status of 
Fannie Mae and Freddie Mac, but sought to increase the public benefits they provide or reduce 
the government benefits they receive, it could pursue a wide range of options. Illustrative of 
the many options that have been suggested are: strengthening the affordable housing goals by 
requiring Fannie Mae and Freddie Mac to increase their market shares or to direct more 
activity to targeted areas or borrowers; requiring the GSEs to subsidize affordable housing 
directly, through programs analogous to the Federal Home Loan Banks' Affordable Housing 
Program; requiring increased involvement in financing multifamily mortgages; requiring more 
directed assistance (both educational and financial) to lower-income borrowers, state and local 
governments, and non-profit organizations; limiting the size of the GSEs' retained mortgage 
portfolios; freezing or reducing the conforming loan limit; removing certain benefits of GSE 
status, such as the exemption from registering securities with the SEC; and requiring periodic 
estimation and public disclosure of the value of the government benefits that the GSEs receive. 



10 

These options need further analysis before a decision can be made on whether or how to adjust 
government sponsorship. 

Conclusions 

Fannie Mae and Freddie Mac have succeeded in developing a liquid secondary 
mortgage market for conforming, conventional mortgages. Congress, while recognizing the 
important benefits provided by the GSEs' activities, has asked whether it is now both feasible 
and advisable to change their status. 

The securitization techniques and other secondary mortgage activities originally 
pioneered by Ginnie Mae, Fannie Mae, and Freddie Mac are now well-established. They are 
practiced by many fully private firms and are applied not only to non-conforming mortgages 
but to many other types of obligations. For these reasons, there seems little doubt that the 
secondary market for conforming, conventional mortgages could operate efficiently and 
effectively even if Fannie Mae's and Freddie Mac's government sponsorship were altered. 

The more critical issue is whether the benefits of a change would be sufficient to 
outweigh the disruption and risks to the home mortgage market that it might entail. 

Government sponsorship provides benefits to Fannie Mae and Freddie Mac that are 
quite tangible, even though the federal budget does not report them. Any quantification is, of 
course, uncertain. Taking into account the reduced borrowing and operating costs associated 
with GSE status, we estimate these benefits to be on the order of $6 billion annually. 

These government benefits should, in turn, be compared to the benefits that Fannie 
Mae and Freddie Mac provide, in reduced mortgage costs and in access to mortgages, that 
would not otherwise be available. These benefits are even more difficult to estimate with 
confidence. One plausible estimate would be that Fannie Mae and Freddie Mac reduce 
average mortgage costs by perhaps 30 basis points in their part of the market, for a total 
savings to consumers of some $4 billion annually; however, there are many ways in which 
such an estimate could be refined. 

The pass-through estimates do suggest the effect the GSEs have on mortgage rates but 
do not distinguish between a pure pass-through of GSE benefits and the two firms' technical 
and managerial efficiency. Although ending government sponsorship would remove the 
former, it may have no effect on the latter. 

Combining the estimates of a $4 billion pass-through with the $6 billion of the GSEs' 
benefits of federal sponsorship, implies the GSEs' shareholders retained in pre-tax income 
approximately $2 billion of GSE benefits. This estimate is generally consistent with 
comparable estimates reported by CBO (1996) and GAO (1996-A). 



11 

Not included in these pass-through estimates is the extent to which the GSEs provide 
added value through their affordable housing activities. The extent to which their affordable 
housing activities would be affected by ending the GSEs' government sponsorship is uncertain. 
With HUD's affordable housing goals still relatively new, it is premature to judge how much 
of the GSE activity is driven by HUD's administration of these requirements, and how much 
by the basic business objectives of Fannie Mae and Freddie Mac. 

Ending or modifying government sponsorship would entail risk, but would have 
potential benefits. Its potential effect on mortgage interest rates would represent an important 
risk, as would any potential negative consequence for the availability of credit for affordable 
housing. Potential benefits could include increased market competition, more efficient credit 
allocation, reduced U.S. government borrowing costs, and reduced potential risk to taxpayers. 

Although the analysis undertaken in this report and others is substantial, we believe 
firm conclusions regarding the desirability of ending or modifying government sponsorship of 
Fannie Mae and Freddie Mac are premature. The GSEs' experience under the 1992 Act is 
relatively short, and many of the most important issues could benefit from further study. 
Furthermore, should Congress decide to act, there are several possible approaches, each with 
different implications that should be analyzed and reviewed. 

Fannie Mae and Freddie Mac are important institutions participating in markets that 
affect the homeownership of millions of Americans. Ultimately no change will be made 
without rigorous public discussion and a broad consensus. We hope this report is helpful to 
that process. 



Chapter I reviews the legislative history of Fannie Mae and Freddie Mac and describes 
their business operations. Chapter II examines the benefits and constraints of government 
sponsorship in relation to the two GSEs' business operations. Chapter III discusses the GSEs' 
activities, both in the general secondary mortgage market and in financing affordable housing. 
Chapter IV considers potential effects — both for housing finance and for the GSEs themselves 
— of ending the GSEs' government sponsorship and provides a brief review of issues for 
further study that could alter the federal government's relationship with the GSEs. 



13 
INTRODUCTION 



Two private companies created by the federal government supplement the flow of 
credit to the residential mortgage market. The Federal National Mortgage Association (Fannie 
Mae), established in 1938, and the Federal Home Loan Mortgage Corporation (Freddie Mac), 
established in 1970, purchase mortgages originated by banks, savings associations, mortgage 
bankers, and other lenders. Combined, the two enterprises had approximately $1.4 trillion in 
assets and outstanding mortgage-backed securities at the end of 1995. 

Fannie Mae and Freddie Mac are known as government-sponsored enterprises (GSEs).' 
GSEs are privately owned financial intermediaries with federal charters that limit their 
corporate activity to a specific credit function. The government has created GSEs to overcome 
perceived shortcomings in various credit markets, mainly those for housing, agriculture, and 
higher education loans. As financial intermediaries, the GSEs raise funds in the capital market 
to make or purchase loans, issue pass-through securities, or guarantee the liabilities of others. 

The federal government does not guarantee or stand behind the liabilities of any GSE. 
Nonetheless, capital- market investors believe that the federal government implicitly backs the 
GSEs, enabling the GSEs to operate under favorable terms. The GSEs also receive other 
substantial benefits from federal sponsorship, such as their securities having equal standing 
with Treasury securities as permissible investments for national banks. 

Shortly after the savings and loan debacle, Congress requested several government 
studies on the extent to which GSEs pose risks to the taxpayers. Although the reports 
identified no immediate problems with the GSEs' safety and soundness or federal oversight,^ 
they focused attention on the need to strengthen the federal government's oversight of Fannie 
Mae and Freddie Mac. At the time, these two GSEs - huge institutions with capital ratios 
lower than most financial firms - lacked a true safety-and-soundness regulator. 

Partially in response to these reports, Congress enacted the Federal Housing Enterprises 
Financial Safety and Soundness Act of 1992 [P.L. 102-550], which created the Office of 
Federal Housing Enterprise Oversight (OFHEO). As the safety and soundness regulator for 
Fannie Mae and Freddie Mac, OFHEO establishes and enforces capital requirements and 
examines the GSEs' operations. 



' Other GSEs include the Federal Home Loan Bank System (FHLBank System), tlie Farm Credit System 
(PCS), the Federal Agricultural Mortgage Corporation (Farmer Mac), the Student Loan Marketing 
Association (Sallie Mae), and the College Construction Loan Insurance Association (Connie Lee). 

^ See U.S. Department of the Treasury (1990, 1991), U.S. General Accounting Office (1990, 1991), and 
Congressional Budget Office (1991). 



14 

At the same time, Congress required a further set of reports to consider a larger 
question: Should Fannie Mae and Freddie Mac retain their existing ties to the federal 
government? Congress required the Secretary of the Treasury, the Secretary of Housing and 
Urban Development (HUD), the Director of the Congressional Budget Office (CBO), and the 
Comptroller General, who heads the General Accounting Office (GAO), to examine the 
desirability and feasibility of ending the federal government's sponsorship of Fannie Mae and 
Freddie Mac, and removing all indicia of such sponsorship, including federal charters and the 
benefits and constraints of GSE status. Using the shorthand term privatization to refer to such 
changes,' Congress asked that the reports consider the consequences of having Fannie Mae and 
Freddie Mac operate as fully private entities under state corporate charters, with their 
shareholders and management determining the nature and scope of their business activities 
(unconstrained by any specific limitation or requirement of federal law). 

To fulfill our responsibilities under this statutory mandate, we sought information from 
many sources. We reviewed previous government studies and non-government- sponsored 
research on the question of ending a GSE's government sponsorship. We examined the 
legislative history relating to Fannie Mae and Freddie Mac and discussed the GSEs' 
relationship to the government with senior officials of both companies. We reviewed and 
analyzed financial data provided by the two GSEs and data on the residential mortgage market 
and other asset-backed securities markets. We met with participants in the financial services 
and housing industries to discuss trends in mortgage finance and the potential effects of ending 
the GSEs' government sponsorship. 

We also joined HUD, CBO, and GAO in sponsoring five academic research papers that 
examine the issues raised in the mandate. The papers were presented in seminars, subjected to 
academic review, and published, along with reviewers' written comments, in a compendium 
entitled Studies on Privatizing Fannie Mae and Freddie Mac.'^ Fannie Mae and Freddie Mac 
participated in the seminars, offering their views on the methodology and findings of each 
paper. These studies provide valuable research on the issues and represent important 
contributions to the literature on Fannie Mae and Freddie Mac. However, the studies express 
the views of the authors and reviewers, and not necessarily those of the Treasury, HUD, CBO, 
or GAO. 

This report considers the following questions: To what extent have Fannie Mae and 
Freddie Mac accomplished their public purposes? Do public policy reasons exist for 



' As Fannie Mae and Freddie Mac are already privately owned, with stock traded on the New York Stock 
Exchange, the changes involved would differ from privatizing a government agency or government-owned 
corporation. 

" U.S. Department of Housing and Urban Development, Studies on Privatizing Fannie Mae and Freddie 
Mac, prepared for the U.S. General Accounting Office, U.S. Department of Housing and Urban 
Development, U.S. DeparUnent of the Treasury, and Congressional Budget Office, May, 1996. 



15 



continuing the benefits and constraints that GSE status imposes on Fannie Mae and Freddie 
Mac? What would be the broader potential effects of ending the government's sponsorship of 
Fannie Mae and Freddie Mac? What would be the consequences of maintaining the status 



quo! 



17 



CHAPTER I 

FANNIE MAE, FREDDIE MAC, AND THE 
HOUSING CREDIT MARKET 



Fannie Mae has undergone several significant changes over the course of its history, 
but its primary public purpose remains the same: providing liquidity to housing finance by 
maintaining an active presence in the secondary mortgage market. Freddie Mac serves the 
same basic public purpose. The federal government saw a need for such institutions because 
of market imperfections in the supply of credit to housing finance. Depression-era economic 
conditions highlighted these imperfections, as did the inflation-driven problems of the financial 
system during the 1960s through 1980s. 

A. The Creation AND Evolution OF Fannie Mae AND Freddie Mac: A Historical 
Overview 

Financial turbulence during the Great Depression overwhelmed the housing finance 
system. At the time, the most common form of housing finance was a balloon mortgage, 
which required a large downpayment and periodic interest-only payments over a relatively 
short repayment period (generally between one and six years). When the full principal became 
due at the end of that period, the lender (usually a bank or savings and loan) decided whether 
to renew the loan. As the Depression deepened, borrowers often could not make their balloon 
payments, lenders often could not refinance loans, and home prices fell. The cumulative result 
was a precipitous drop in new financing activity and a collapse of home construction. 

In 1932, Congress responded by creating the Federal Home Loan Bank System to 
support the local institutions that specialized in housing finance — savings associations and 
savings banks. The Federal Home Loan Banks were designed to provide liquidity for long- 
term mortgages that replaced balloon mortgages. Using their mortgage portfolios as collateral, 
member institutions could fund greater lending activity by borrowing money from their 
regional Federal Home Loan Banks. 

To encourage mortgage lending by shielding lenders from default risk, the government 
created the Federal Housing Administration (FHA) in 1934. The FHA provided mortgage 
default insurance and promoted the long-term fully amortizing mortgage. FHA insurance also 
expanded access to credit by facilitating lower downpayments. 

But lenders remained reluctant to tie up their funds in illiquid long-term mortgages, a 
problem the government addressed in 1938 by creating Fannie Mae to support a secondary 
market in FHA-insured mortgages. Fannie Mae raised funds in the national capital markets 
and purchased FHA-insured mortgages nationwide, primarily from banks and mortgage 



18 

bankers. It also resold such mortgages to other investors. Fannie Mae's activities made the 
FHA loan market more liquid and promoted the development of FHA mortgage lending 
nationwide. Fannie Mae was also designed to bring a degree of stability to the mortgage 
market. During periods of tight money, Fannie Mae could make mortgage credit more 
available by purchasing mortgages, selling them later to investors when credit conditions 
eased. 

In its early years, Fannie Mae purchased relatively few mortgages. With the post- 
World War II growth in housing, however, Fannie Mae began building its mortgage portfolio. 
In 1948, the government facilitated further growth by authorizing Fannie Mae to purchase 
mortgage loans guaranteed by the Veterans Administration (VA). 

In the 1954 Federal National Mortgage Association Charter Act [P.L. 83-560], 
Congress directed Fannie Mae to begin liquidating its mortgage portfolio' and act more as a 
conduit (i.e., selling mortgages it bought to other investors, then recycling the sales proceeds 
back into the primary mortgage market). To ensure that Fannie Mae could resell any 
mortgages it purchased, the Act revised Fannie Mae's charter to restrict it generally to 
purchasing mortgages that met the purchase standards of private institutional mortgage 
investors. The 1954 Act also transformed Fannie Mae into a mixed-ownership government 
corporation and provided for its gradual transfer to private ownership. 

Congress completed that transfer in 1968 by dividing Fannie Mae into two parts: a 
privately owned corporation (which retained the name Federal National Mortgage 
Association), and a new government corporation (the Government National Mortgage 
Association, or Ginnie Mae) within HUD.^ The new Fannie Mae was now a government- 
sponsored enterprise: owned by stockholders who elected a majority of the company's 
directors, yet limited by its charter to providing supplemental assistance to the secondary 
market for FHA/VA mortgages. Ginnie Mae became responsible for providing a secondary 
market for special housing programs and liquidating the old Fannie Mae's remaining mortgage 
portfolio. 

Fannie Mae, the Federal Home Loan Banks, and other secondary market investors 
helped depository institutions weather episodes of tight money, but could not offset the 
macroeconomic disruptions that began in the 1960s. As inflation increased during the 1960s 
and 1970s, interest rates began climbing. The combination of rising interest rates and interest- 
rate ceilings imposed by the government under Regulation Q caused acute problems for 



'Weicher(1994, p. 53). 

^ Weicher (1988, pp. 310-11) identifies the federal government's 1967 budget reforms as a key reason for 
splitting Fannie Mae. Under the new unified budget rules, Fannie Mae's mortgage purchases counted as 
budgetary outlays. Reconstituting Fannie Mae as a privately owned corporation kept its mortgage 
purchases off-budget. 



19 

housing finance.' When interest rates on alternative investments exceeded the Regulation Q 
ceilings, depositors had an incentive to move their funds out of depository institutions. This 
disintermediation process disrupted the flow of credit to finance housing. Regulatory 
restrictions on depository institutions' geographic and portfolio diversification also contributed 
to uneven regional flows of housing credit. 

In response to the credit crunch of 1969-70 and to regional disparities in mortgage 
credit availability, Congress adopted two changes in 1970. First, Congress permitted Fannie 
Mae to begin purchasing conventional mortgage loans (i.e., non-FHA, non-VA mortgages). 
Second, Congress created the Federal Home Loan Mortgage Corporation (Freddie Mac) within 
the Federal Home Loan Bank System (which was owned cooperatively by thrift institutions) to 
provide a secondary market for conventional loans, many of which were held by savings and 
loans. By fostering a secondary market in conventional mortgages, Congress sought to make 
mortgage credit more available, mitigate the effect on savings and loans of Regulation Q- 
related credit crunches, and improve the regional distribution of housing finance credit. 

Fannie Mae responded to its new powers by rapidly building its mortgage portfolio, 
which soon exceeded that of even the largest savings and loan institution.'' Indeed, Fannie 
Mae's balance sheet looked much like that of a savings and loan, with its assets nearly all in 
long-term, fixed-rate mortgages and its liabilities relatively short-term. When interest rates 
soared in the late 1970s and early 1980s, Fannie Mae encountered some of the same 
difficulties as did savings and loans, and by 1981 had a negative net worth of almost $11 
billion. 

Freddie Mac's initial business strategy differed from Fannie Mae's. Instead of 
competing with its thrift-institution owners by holding mortgages in portfolio, Freddie Mac 
followed Ginnie Mae's lead and focused on securitizing mortgages.^ 



' The Federal Reserve Board's Regulation Q, adopted pursuant to a 1933 Act of Congress, limited the 
interest rates banks paid on deposits. In 1966, Congress authorized the Federal Home Loan Bank Board to 
impose similar limits on the interest rates savings and loan institutions paid on deposits (although in 
practice the limits for savings and loans were slightly higher than those for hanks). The remainder of this 
report will use Regulation Q to refer to both the Federal Reserve's limits on banks and the Federal Home 
Loan Bank Board's limits on savings and loans. 

''Weicher(1994, p.55). 

' A basic description of securitization follows in the next section. Ginnie Mae does not actually securitize 
or purchase mortgages but facilitates the securitization of FHA and VA mortgages by guaranteeing the 
timely payment of principal and interest on the underlying pool of FHA and VA mortgages that make up 
mortgage-hacked securities issued by apprt)ved private sector entities. Ginnie Mae's guarantee carries the 
full faith and credit of the United States. In what follows in this study, the term securitize or purchase in 
relation to Ginnie Mae will refer to this guarantee function. 



20 

Both Fannie Mae and Freddie Mac grew rapidly through the mid-eighties, partly due to 
increases in the size of loans they were allowed to purchase and to an expansion of the market 
fostered by new product development. With much of the thrift industry under stress by the 
end of the 1980s, and with Fannie Mae and Freddie Mac increasingly important in housing 
finance, Congress sought to adapt the GSEs' structure and public purpose to changing 
conditions and ensure the GSEs' safety and soundness. In 1989, the ownership of Freddie 
Mac was restructured to include a new class of freely transferable voting common stock, like 
Fannie Mae's, thereby removing restrictions that had generally limited its ownership to thrift 
institutions. In 1992, Congress established the Office of Federal Housing Enterprise Oversight 
(OFHEO) as the safety and soundness regulator for Fannie Mae and Freddie Mac and refined 
the two GSEs' mission statements to broaden their market of affordable housing loan activities. 

B. Secondary Mortgage Market Operations of Fannie Mae and Freddie 
Mac 

Fannie Mae and Freddie Mac operate in the secondary market for residential mortgage 
loans, as required by their charters. Consequently, they do not make mortgage loans directly 
to homebuyers. Instead, they buy mortgages from mortgage lenders and finance these 
purchases by creating and selling securities backed by pools of mortgages (securitization) or by 
issuing debt securities and retaining the mortgages in their own portfolio. (Figure 1. 1 depicts 
this intermediation process.) The GSEs' charters preclude them from buying one-family 
mortgages over a specified threshold (currently $207,000) known as the conforming loan limit, 
which is based on an annually adjusted market index. 



21 



Figure I.l: Secondan/ Market Operations of Fannie Mae and Freddie Mac 



Investors 



Portfolio 
Lending 



GSE Debt Securities 
Issued to Finance 
Mortgages 



GSE 



Lenders 



Borrowers 



Securities 
Guarantee 



GSE-Guaranteed 
Mortgage Backed 
Securities Issued 



Fannie Mae and 
Freddie Mac 

Buy Mortgages 



Thrifts, Banks, 
Mortgage Bankers, 
Credit Unions 



Homeowners and 
Apartment 
Owners 



Source: GAO (1990, p. 26). 



22 

Securitization involves transforming illiquid mortgage loans into liquid, tradeable 
mortgage-backed securities, which represent interests in a pool of loans. While Fannie Mae 
and Freddie Mac sometimes buy individual mortgages from lenders, more often they buy a 
group of mortgages at once. In a typical transaction, the GSE buys mortgages with similar 
interest rate structures, age, and underwriting characteristics from a lender who retains a 
portion of the monthly mortgage payinents as compensation for servicing the pool of loans. 
The GSE retains a guarantee fee, and passes the remaining portion of the monthly mortgage 
payments on to the ultimate investors, the holders of the mortgage-backed securities for that 
loan pool. 

While investors bear the interest rate risk*^ associated with holding mortgage-backed 
securities, Fannie Mae and Freddie Mac bear a part of the credit risk by guaranteeing the 
payment of principal and interest to the investors. The guarantee fee retained by the GSEs is 
essentially an insurance premium for this guarantee. 

The mortgage-backed securities issued by Fannie Mae and Freddie Mac vary based on 
the characteristics of the mortgages. Stripped mortgage-backed securities separate the 
principal and interest payment obligations into distinct classes of securities. Real estate 
mortgage investment conduits (REMICs), a tax-advantaged structure, issue securities that 
represent a beneficial interest in a fixed pool of mortgages. Like other mortgage-backed 
securities, REMICs pay investors using the cash flows from the underlying mortgages or 
mortgage-backed securities. However, the principal and interest payments are allocated in 
various ways among tranches with short-, intermediate-, and long-term maturities. Most 
classes receive current interest payments on the outstanding principal, but do not receive 
principal payments until all previous maturity classes are retired.^ 

Like depository institutions, Fannie Mae and Freddie Mac also buy and hold individual 
mortgages in their retained portfolio, which poses both credit risk and interest rate risk. The 
retained portfolio generates income from the difference between the interest rate the borrower 
pays (net of the servicing fee paid to the loan servicer) and the interest rate the GSE pays for 
its funds, minus the GSE's operating costs and credit losses. Unlike depository institutions. 



* Interest rate risk refers here to changes in the value of mortgages occurring because of changes in market 
interest rates. Like all other loans and securities, mortgages change in value as interest rates rise or fall. 
This aspect of interest rate risk is especially important in the case of fixed-rate, as opposed to adjustable- 
rate, mortgages. Since changes in interest rates also affect the likelihood that a borrower will prepay a 
mortgage, prepayment risk represents another aspect of the interest rate risk associated with mortgages. 
Credit risk refers to the risk that a borrower will not pay principal and interest promptly or will otherwise 
default on the loan. 

' The payment characteristics of most REMICs are similar to a collateralized mortgage obligation (CMO) 
from an investor's viewpoint. A CMO is a mortgage-backed bond — a debt instrument collateralized by a 
pool of mortgages — that consists of different classes of certificates maturing at different dates. However, 
tax treatment favors the REMIC structure. 



23 

which fund their mortgage portfolios primarily by taking deposits, the two GSEs fund their 
portfolios by issuing an array of debt securities. 

C. Summary 

Fannie Mae and Freddie Mac serve a public purpose: providing stability and liquidity 
to the secondary market for conforming home mortgage loans, including affordable housing 
loans. As secondary market institutions, Fannie Mae and Freddie Mac purchase conforming 
residential mortgage loans from banks, thrifts, mortgage banks, and other mortgage loan 
originators. The GSEs finance these purchases by securitizing groups of mortgages or by 
holding the mortgages in portfolios funded by issuing debt securities. Securitization involves 
pooling groups of mortgages and issuing securities backed by the pooled mortgages to 
investors. Mortgage-backed securities represent interests in the underlying mortgages, and use 
borrowers' monthly payments of interest and principal to pay the investors. The GSEs 
guarantee these payments and, in return, collect a guarantee fee. To help the GSEs pursue 
these activities while keeping within their public mission, government sponsorship confers a 
range of benefits and constraints, discussed in Chapter II. 



25 
CHAPTER n 

GOVERNMENT SPONSORSHIP OF FANNIE MAE AND FREDDIE MAC 



In establishing Fannie Mae and Freddie Mac, Congress imposed a set of constraints in 
their charters that limit them to certain business activities and keep them focused on housing. 

Government sponsorship also includes a range of benefits to Fannie Mae and Freddie 
Mac that assist them in these efforts. These include exemption from costs that other financial 
institutions must bear, an ability to borrow at costs lower than other financial institutions, and 
the freedom to operate with less equity capital than a comparable fully private firm. These 
benefits are not reported in the federal budget because they do not take the form of direct 
payments to either GSE. Nonetheless, the benefits are extremely valuable. This chapter 
describes the benefits, and attempts to quantify them and to assess what portion of them the 
two GSEs pass through to consumers in the form of lower mortgage rates and what portion the 
GSEs' shareholders retain. 

A. Benefits and Constraints of Government Sponsorship 

Although they are federally chartered, Fannie Mae and Freddie Mac receive no funds 
from the federal government and the government does not guarantee their securities. 
However, government sponsorship does provide a set of benefits that would command a high 
price if offered to fully private firms. Thus, while the GSEs pose no direct budgetary cost to 
taxpayers, taxpayers provide the GSEs with benefits that have substantial value, an estimate of 
which is provided in Section B. 

Government sponsorship also involves certain constraints - most significantly, those 
limiting the firms' operations to the specific areas permitted by their charters. Thus, the GSEs 
forego the opportunity to invest their shareholders' capital in activities outside the boundaries 
of their charters. 

1. Benefits of Government Sponsorship 

Government sponsorship provides Fannie Mae and Freddie Mac with three types of 
benefits that help them fulfill their public mission. First, it lowers their operating costs and 
makes their securities more liquid and more attractive to investors. Second, it enables them to 
operate with relatively less capital than other market participants. Third, it enables their debt 
securities and mortgage-backed securities to receive preferential treatment in financial markets. 
These benefits help to support the GSEs' securitization and portfolio-holding activities. 



26 

The first set of benefits subsidizes the GSEs' operations by lowering their costs, which 
should increase the supply and stability of credit to the housing finance market. These benefits 
include among other things: 

exempting their debt securities and mortgage-backed securities (for simplicity, their 
securities) from registration with the Securities and Exchange Commission; 

exempting the GSEs from state and local corporate income taxes; 

authorizing the Secretary of the Treasury to purchase up to $2.25 billion of each GSE's 
obligations (and thus extend credit to the GSE); 

making their securities eligible as collateral for public deposits and for loans from 
Federal Reserve Banks and Federal Home Loan Banks; 

permitting national banks to make unlimited investments in those securities; 

making those securities lawful investments for federal fiduciary and public funds; 

authorizing the GSEs to issue and transfer securities through the book-entry system 
maintained by the Federal Reserve; and 

authorizing the Federal Reserve to buy and sell their securities in open market 
operations. 

In addition, regulatory capital requirements for depository institutions create an 
incenUve for those institutions to hold mortgage-backed securities rather than whole mortgages 
- in effect giving them a financial incentive to sell in the secondary market the mortgages they 
originate. An excerpt from Freddie Mac's Information Statement makes this clear: 

Risk-based capital regulations adopted by the various federal bank and savings 
association regulatory agencies have become a significant factor in secondary 
mortgage market transactions, affecting both Freddie Mac's single-class and 
multiple-class securities programs. Among other things, these regulations 
assign lower credit risk weights to mortgage-related securities issued or 
guaranteed by Freddie Mac and the Federal National Mortgage Association 
("Fannie Mae") than to the underlying mortgages themselves, thereby requiring 
regulated financial institutions to maintain higher levels of capital for a given 
quantity of portfolio mortgages than would be required for an equivalent 
quantity of mortgage-related securities. Consequently, banks and saving 



27 

associations have a financial incentive to sell and/or securitize mortgages rather 
than hold them as portfolio investments.' 

Government sponsorship also enables the GSEs to operate with less capital than a 
comparable fully private firm, without incurring higher borrowing costs. How much capital 
such a firm would hold is speculative, because no fully private firm just like Fannie Mae and 
Freddie Mac exists. Depository institutions are currently the GSEs' principal competitors for 
portfolio funding of residential mortgages. The regulatory capital requirements for mortgages 
currently imposed on Fannie Mae and Freddie Mac are low relative to those imposed on 
FDIC-insured depository institutions. At the end of 1995, the two GSEs had an average 
capital-to-assets ratio of 3.9 percent. That ratio falls to 2.75 percent if one allocates capital, at 
the minimum rate currently required by the GSEs' safety and soundness regulator, to the $972 
billion in mortgage-backed securities that the GSEs have guaranteed but do not carry on their 
balance sheets. By contrast, FDIC-insured savings institutions, with investments 
predominantly in mortgage-related assets, had an average capital-to-assets ratio of 7.8 percent. 
Although the differences may largely, or completely, reflect broad differences in the average 
credit and interest rate risk exposures of GSEs and depository institutions, the differences 
would provide a substantial competitive advantage to the GSEs even over depository 
institutions with essentially equal risks. Both depository institutions and the GSEs fund their 
mortgage portfolios using a mix of capital and debt, and capital is generally a more expensive 
funding source than debt. By having lower relative capital requirements than depository 
institutions, while simultaneously having an advantage in issuing debt as described below, the 
GSEs can finance a given mortgage or group of mortgages in their portfolio with less capital — 
and hence at lower cost — than can depository institutions. 

The third type of benefit associated with GSE status is the preferential treatment that 
financial markets accord to debt and mortgage-backed securities issued by Fannie Mae and 
Freddie Mac relative to securities issued by potentially higher-capitalized, fully private, but 
otherwise comparable firms. 

By law, all GSE-issued securities carry a disclaimer stating that securities are not 
guaranteed by, or otherwise an obligation of, the federal government. Yet the market prices 
for those securities, and the fact that the market does not require that those securities be rated 
by a national rating agency, suggest that investors believe the government implicitly guarantees 
those securities. This perception of an implicit guarantee — growing out of the numerous ties 
between the GSEs and the federal government — enables Fannie Mae and Freddie Mac (and 



' Federal Home Loan Mortgage Corporation (1993, p. 9). 



28 

the other GSEs) to borrow at near-Treasury rates -- rates below those paid by AAA-rated 
private firms. ^ 

2. Constraints of Government Sponsorship 

In exchange for the benefits of GSE status, the two GSEs' charters limit them to 
operating in the secondary mortgage market, and within that market to purchasing loans only 
up to a certain size. The maximum original principal amount of a mortgage they may purchase 
is set by formula.^ Mortgages with original principal amounts equal to or less than the 
conforming loan limit are called conforming loans or conforming mortgages.^ Over 90 percent 
of mortgages qualify for purchase under the limit.'' At the end of 1995, total one-to-four 
family mortgage debt outstanding were about $3.4 trillion, about $2 trillion of which was in 
conventional, conforming fixed-rate mortgages, according to a GAO report (1996, p. 57) 
based on Freddie Mac estimates. At the end of 1995, Fannie Mae and Freddie Mac were 
financing about $1.3 trillion in conforming mortgages. Thus, even operating within these 
limits, the two GSEs have become extremely large institutions. 

Fannie Mae and Freddie Mac also face the following requirements not applicable to 
most private entities: 

• The GSEs must meet a set of housing goals established by HUD to ensure that the 
GSEs' mortgage purchases include loans to targeted borrower groups and underserved 
areas. (Chapter III discusses these requirements in more detail.) 

• The President, rather than shareholders, appoints some members of the GSEs' boards 
of directors. 



^ National credit rating agencies employ various designations to denote the highest credit rating for private 
firms. For example, Standard and Poor's Corporation uses AAA and Moody's Investors Service Inc. uses 
Aaa. In the remainder of this study, AAA will denote the highest credit rating available to private firms. 

' The formula limits increases in the conforming loan limit to increases in average home prices as 
measured by the Federal Housing Finance Board's survey of mortgage lenders. Several controversies 
exist regarding the conforming loan limit. The index used fell in 1993 and 1994 but the GSEs did not 
lower the conforming loan limit accordingly, arguing that the law stipulates only how the index should 
control increases in the conforming loan limit. When the index rose in 1995, both GSEs increased the 
conforming loan limit even though the increase in the index was less than the previous two years' decline. 
For more information on tlie process used to set the conforming loan limit, see U.S. General Accounting 
Office (1994). 

* In 1996, the conforming loan limit for one-family mortgages is $207,000, with higher limits in Alaska 
and Hawaii. The limits increase for two-, three-, and four-family mortgages. Limits also exist for 
multifamily mortgages. 

' Canner and Passmore (1995-A) estimate that 7.5 percent of the number of single-family mortgage loans 
originated in 1994 exceeded the conforming loan limit. 



29 

• The Treasury Department has statutory authority to approve the GSEs' new debt issues, 
and has used this authority to coordinate new debt issues of the GSEs to prevent inartcet 
congestion. 

• The GSEs are subject to regulatory oversight and will be subject to risk-based capital 
requirements. 

B. Estimating the Value of Government Sponsorship 

The benefits that Fannie Mae and Freddie Mac receive from government sponsorship 
have real economic value, and thus provide an in-kind subsidy. The GSEs also pass through 
benefits of such sponsorship to the homebuying public in the form of lower mortgage interest 
rates. How do the benefits that the GSEs receive compare in value to the benefits they pass 
through to the public? Relying on the best data available to us, we present a conservative 
estimate of the most significant governmental benefits that the GSEs receive and an estimate of 
those they confer (lower interest rates on fixed-rate conforming, conventional single-family 
mortgages). 

As estimated here, the gross value (that is, the value before considering any pass- 
through to homebuyers) includes the value of GSE benefits related to mortgage securitization, 
the retained mortgage portfolio, and reduced operating costs. From the gross value of these 
benefits, we subtract the estimated value passed on to homeowners to arrive at the net subsidy 
retained by the GSEs. These estimates reflect the value of GSE benefits based on the GSEs' 
current operations and do not imply that the GSEs' would operate in the same way they do 
today if Congress ended their government sponsorship. Nor do these estimates imply how a 
change in their government sponsorship would affect the GSEs' future operations or 
profitability. 

1. Benefits Related to Securitizing Mortgages 

Investors pay a premium (accept a lower yield - effectively a lower interest rate) to 
purchase Fannie Mae and Freddie Mac mortgage-backed securities in comparison to securities 
with comparable asset-backing issued by non-GSEs (private conduits).* This advantage to the 
GSEs derives primarily from investors' perception that the government implicitly guarantees 
such securities even though no formal guarantee exists. An estimate of the value of the GSE 
benefits relating to mortgage-backed securitization should at least equal the extent to which 
investors are willing to accept lower yields because of that perception. 



* Hermalin and Jaffee (1996) provide a theoretical analysis of the premium investors are willing to pay for 
the GSEs' mortgage-backed securities. 



30 

Goodman and Passmore (1992, p. 5) found a yield difference of 45 to 60 basis points 
between the GSEs' mortgage-backed securities and AA-rated private mortgage-backed 
securities. Based in part on this result and other sources, CBO (1996) cited a range of 25 to 
60 basis points as the GSEs' advantage in issuing mortgage-backed securities; CBO used 40 
basis points as its baseline estimate of the advantage. 

In discussions with OFHEO and market participants, we have attempted to obtain 
additional evidence on this issue. Several market participants told OFHEO officials that over 
the last three years the yields on the GSEs' mortgage-backed securities collateralized by 30- 
year fixed-rate loans have been 35 to 65 basis points lower than the yields on comparable 
privately issued mortgage-backed securities.^ This spread reflects the prices of both the senior 
and subordinated pieces of the privately issued mortgage-backed securities. 

Mortgage-backed securities issued by the GSEs have structures dissimilar to those 
issued by private conduits, which complicates interpretation of this yield difference. The two 
GSEs guarantee the principal and interest payments of their mortgage-backed securities and 
collect a fee for providing this credit enhancement. Private conduits, instead of charging a 
guarantee fee to credit-enhance a pool of mortgages, frequently rely on a structure that splits 
the mortgage-backed securities into senior and subordinated pieces. The senior piece typically 
obtains an AAA rating since the subordinated piece absorbs most of the risk in the mortgage 
pool. In return, the holders of the subordinated piece receive a higher yield as compensation 
for the higher risk, which in effect becomes the cost of the credit enhancement for privately 
issued mortgage-backed securities. Therefore, the 35 to 65 basis point range based on all 
senior and subordinated private-label pieces overstates the GSEs' advantage. 

A market participant suggested that adjusting the 35 to 65 basis point yield spread to 
reflect the yield difference on senior securities alone would lower the range to between 13 and 
46 basis points. This range underestimates the GSEs' advantage in issuing mortgage-backed 
securities, however, because the comparison assumes that the GSEs' corporate guarantees of 
their mortgage-backed securities are equivalent to the credit enhancement necessary to obtain 
an AAA rating. It seems unlikely that credit rating agencies would assign the highest 
investment-grade credit rating to mortgage-backed securities based solely on the credit 
enhancement provided by the corporate guarantees of fully private firms that had risk 
exposures and capital levels comparable to those of the GSEs. 



' According to OFHEO's sources, since 1992 the prices of GSE mortgage-backed securities have exceeded 
by 1.5 percent to 3 percent the prices of privately issued mortgage-backed securities backed by 30-year 
fixed-rate mortgages of credit quality comparable to loans securitized by the GSEs. This price differential 
reflects all senior and subordinated securities that comprise privately issued mortgage-backed securities. 
When appropriate assumptions about the different expected prepayment speeds of GSE and privately issued 
mortgage-backed securities are used to calculate yields to maturity, the price differences imply the yield 
spreads cited in the text. 



31 

Based on the 25 to 65 basis point range reported by CBO (1996), and the basis point 
ranges suggested by market participants, the analysis presented here assumes that Fannie 
Mae's and Freddie Mac's GSE status gives their mortgage-backed securities a 35 basis point 
yield advantage in the market.* This estimate is necessarily only approximate. A more precise 
estimate would require extensive gathering and analysis of market data on outstanding 
mortgage-backed securities. Even then, the inherent structural differences between GSE- 
issued mortgage-backed securities and privately issued mortgage-backed securities would 
continue to complicate such comparisons. And the size of the GSEs' advantage may change 
over time in response to changing market conditions and growing market acceptance of 
privately issued mortgage-backed securities. 

2. Benefits Related to Retaining Mortgages in Portfolio 

To finance their retained mortgage portfolios, Fannie Mae and Freddie Mac issue debt 
securities. Investors purchase these securities in the bond market at interest rates much lower 
than those paid by institutions with similar risks and more capital. The perception of an 
implicit guarantee makes them appear safer to investors, and some of their characteristics as 
GSE securities enhance their liquidity — in essence lowering the GSEs' borrowing costs. One 
way to estimate these benefits is to compare the GSEs' borrowing costs to those of large high- 
quality financial firms with large portfolios of residential mortgages. Such firms (primarily 
large thrifts and commercial banks) are typically rated about A. 

Using market price data reported by Bloomberg Financial Services, we examined yield 
spreads between the two GSEs' debt securities and similar securities of fully private, A-rated 
financial firms. Bloomberg adjusts its data for the specific characteristics of the bonds and 



' Fannie Mae criticized such estimates for exceeding the guarantee fee it charges customers. Yet the yield 
difference being measured here reflects the price advantage at which the GSEs sell their securities, not the 
guarantee fee they retain. The 35 basis points is also a gross suhsidy, which does not consider any possible 
pass-through to homebuyers. The estimated net subsidy associated with securitization (described later in 
this section) is the 35 basis point estimated yield advantage minus the pass-through of GSE benefits in the 
form of reduced mortgage interest rates. Thus, based on the assumptions made here, if the GSEs lowered 
mortgage interest rates by 30 basis points, then the net subsidy retained by the GSEs in securitizing 
mortgages would be 5 basis points. 

In comments provided to the Treasury, Freddie Mac stated that 30 basis points was a reasonable estimate 
of its funding advantage in issuing mortgage-backed securities, but unfairly measured its GSE benefits, 
since its securities also benefit from a liquidity advantage. Any liquidity premium accruing to the GSEs' 
mortgage-backed securities, however, reflects to some (probably large) degree, liquidity advantages 
derived from their GSE status. 



32 

reports average yield spreads for various maturity ranges."* Comparing yield differences on 
intermediate and long-term securities outstanding over the period from 
December 31, 1991, to April 30, 1996, Bloomberg reports the following average yield 
spreads: 53 basis points on two-year debt, 55 basis points on five-year debt, 52 basis points 
on ten-year debt, and 78 basis points on thirty-year debt. Since the GSEs are not heavy issuers 
of long-term debt, and since the five-year spread most closely approximates the average life of 
a mortgage, we used 55 basis points as the GSEs' funding advantage in issuing intermediate- 
and long-term debt to finance their retained mortgage portfolios. This estimate is consistent 
with White's (1996, p. 309) estimate that the GSEs' borrowing advantage amounts to between 
55 and 60 basis points. '° 

For short-term debt securities, which may (among other things) finance short-term 
liquidity investments, we examined the difference between the yield on the GSEs' discount 
notes and the London interbank offered rate (LIBOR). Fannie Mae and Freddie Mac officials 
said LIBOR was an appropriate measure of banks' and thrifts' short-term funding costs. 
According to Bloomberg, this spread averaged 18 basis points for three-month notes over the 
period available (late 1992 to April 1996). Thus, we used 18 basis points as the baseline 
estimate for the GSEs' funding advantage on short-term debt. 

These figures provide, at best, a rough estimate of the magnitude of the GSEs' 
advantage in issuing debt securities. Data for more careful comparison are not easily found. 
The GSEs have also pointed out that the yield spreads have declined in recent months. 
However, while these spreads are relatively low at the moment, they do vary over the course 
of the business cycle and have been much higher than the average spreads just reported. This 
issue deserves further research. A carefully constructed data set would permit a meaningful 
comparison of historical yield spreads and take proper account of the idiosyncratic features of 
the various securities being compared. To allow for this uncertainty, we also estimated a 
range for the GSEs' long-term and short-term borrowing advantage. 

We used the same Bloomberg data to estimate a range for the GSEs' funding cost 
advantage, going from one standard deviation above to one standard deviation below the mean. 
For the yield spread on five-year debt, the mean was 55 basis points and the standard deviation 



' Bloomberg Financial Services reports the market value of bonds calculated using the Bloomberg Fair 
Value Model. According to Bloomberg, "Bloomberg Fair Value (BFV) is the model level or calculation 
that provides an indication of a bond's market value, based on the trading levels of other debt in its sector, 
as defined by issuer type and perceived credit quality. To account for embedded options BFV quantifies 
the value of any options and depending on option type, adds or subtracts them from the value, effectively 
allowing you to compare bonds with different structures on an equal basis. This model-predicted value is 
free of short-term supply and demand considerations." 

'" White based his estimate on the observation that the difference between GSE securities and corporate 
AAA debt is approximately 30 basis points, and that between AAA and A debt there is another 25-30 basis 
point spread. 



33 

was 19 basis points. Thus, the range for the GSEs' funding advantage in issuing five-year 
debt (our proxy for the GSEs' advantage in issuing intermediate and long-term debt) is 
estimated as 36 to 74 basis points. For short term debt, the mean yield spread was 18 basis 
points with one standard deviation of 15 basis points. Thus, the range for the GSEs' funding 
advantage in issuing short-term debt is estimated as 3 to 33 basis points. 

The GSEs' advantages in issuing debt securities, as measured here, stem largely from 
the superior treatment their debt receives in financial markets, compared to the treatment that 
would be expected for the debt of fully private (and perhaps differently structured) firms, such 
as their current competitors in portfolio mortgage funding. The GSEs' competitive advantage 
is also reflected in the fact that they operate with relatively less capital than fully private firms 
that finance whole mortgages in their portfolio. In fact, whether measured using current 
regulatory capital requirements or actual capital levels, the GSEs operate with considerably 
less capital than do other private financial firms." A company's debtholders look to the 
company's capital level and the relative riskiness of its activities in judging the risk of their 
investment. Other things being equal, a firm's borrowing costs are inversely related to its 
capital level. 

GSE status attenuates this normal disciplining function of the marketplace, reducing the 
GSEs' borrowing costs without requiring commensurately higher levels of capital. Since 
capital is more costly than debt, operating with relatively less capital than private firms adds to 
the GSEs' competitive advantages in funding a portfolio of mortgages. 

3. Benefits That Reduce the GSEs' Operating Costs 

Several GSE benefits, such as the exemption from SEC registration, directly reduce 
Fannie Mae's and Freddie Mac's operating expenses relative to other firms. In addition, the 
GSEs' income is exempt from state and local income taxes. Although we did not attempt to 
identify and value every aspect of GSE status that may reduce the GSEs' operating costs, the 
SEC registration exemption and the state and local income tax exemption are the most 
significant. The GAO (1996-B, p. 7) estimated that in 1995 the state and local income tax 
exemption saved the GSEs a combined $367 million, and the SEC registration exemption 
saved the GSEs $102 million. Rounded off, the GSEs' combined operating cost subsidies 
totaled roughly $500 million last year. Among other things, this estimate does not include any 
operating-cost subsidies that may arise from use of the Federal Reserve's book-entry system. 
Nor does it include savings from issuing securities without obtaining private rating agency 
ratings. 



" See Stanton (1996, pp. 80-83) for comparisons between the GSEs and other financial firms, and between 
the GSEs and other major providers of mortgage credit. 



34 

4. Estimating the Gross and Net Value of Government Sponsorship 

The cumulative value of GSE status to Fannie Mae and Freddie Mac may be estimated 
by combining the value of the benefits they receive in securitizing mortgages, funding 
mortgages in portfolio, and operating at lower costs. The GSEs' so-called gross subsidy 
measures these benefits before considering the extent to which the GSEs pass them on to 
homebuyers in the form of lower mortgage rates. The pre-tax net value of the benefits 
retained by the GSEs is the gross subsidy minus the projected reduction in mortgage rates 
resulting from the GSEs' operations. 

Our analysis assumes that in 1995, government sponsorship gave the GSEs: (1) a 35 
basis point advantage in securitizing mortgages; (2) a 55 basis point advantage in issuing 
intermediate- and long-term debt to fund their mortgage portfolio, and an 18 basis point 
advantage in issuing short-term debt for liquidity investments; and (3) a $500 million 
combined reduction in operating expenses. Other studies have suggested a funding advantage 
similar to or greater in magnitude to these estimates.'^ 

Applying these figures to the GSEs' 1995 average balance sheet produces a $5.8 billion 
baseline estimate of the gross benefits that Fannie Mae and Freddie Mac derive from 
government sponsorship.'^ Applying the ranges for the GSEs' funding cost advantages 
described above, the estimated range for the combined gross benefits to the GSEs is $5 billion 
to $6.5 billion." 

To determine the net value of the GSE benefits retained by the GSEs' shareholders, we 
looked at studies of the extent to which the GSEs pass their governmental benefits through to 
borrowers by lowering interest rates on conforming, conventional fixed-rate mortgages. (Our 
review of the relevant research is described in more detail in Chapter IV.) Such a pass- 
through is inherently difficult to measure. Based on our review of several studies that 



'^ The estimates in this report are broadly consistent with the magnitudes estimated by the CBO (1996) and 
the GAO (1996- A). 

'■' In 1995, the GSEs had outstanding, on average, approximately $960 billion in mortgage-backed 
securities and $384 billion in debt. To classity outstanding debt as short-, intermediate-, or long-term, we 
assumed that the GSEs funded their retained mortgage portfolio ($327 billion) with intermediate- and long- 
term debt, and that the remainder of the GSEs' outstanding debt ($57 billion) was short-term. OFHEO 
(1996- A) provides complete historical statistics. 

'* Unlike the estimates of the GSEs' mortgage funding advantage, the limited data on the GSEs' mortgage- 
backed security yield advantage do not permit calculation of a comparable range. Therefore, to illustrate 
the sensitivity of assuming that the GSEs had a 35 basis point advantage in securitizing mortgages, we 
calculated comparable ranges for the GSEs' combined gross benefits assuming their securitization 
advantage was 30 basis points and 40 basis points. With a 30 basis point advantage, the range becomes 
$4.6 billion to $6.0 billion. With a 40 basis point advantage, the range becomes $5.5 billion to $6.9 
billion. 



35 



estimated interest-rate differentials between conforming and non-conforming, conventional 
mortgages, we assume that the GSEs reduce interest rates on conforming, conventional fixed- 
rate mortgages by roughly 20 to 40 basis points. (Not clear, however, is the degree to which 
this differential may result from such other factors as the GSEs' technical and managerial 
efficiency.) 

Assuming that the GSEs do lower mortgage rates by 20 to 40 basis points by passing 
through benefits of government sponsorship, we took the midpoint of this pass-through range 
as our baseline. Under this assumption, the GSEs passed through $3.9 billion of pre-tax 
benefits and retained $1.9 billion before taxes in 1995.'^ The 20 to 40 basis point range 
produces an estimated range of benefits passed through to homebuyers of $2.6 billion to $5. 1 
billion. 

Although estimates such as that presented above do give a general sense of the 
magnitude of the subsidies involved, no single point estimate should be viewed as a firm 
indicator of the benefits the GSEs receive or pass through. The calculations described above, 
for example, omit important elements of both benefits received and benefits passed through. 
The estimates do not place a value on the added stability the GSEs may give the conforming, 
conventional mortgage market. Nor do they place a value on the extent to which the GSEs 
may make affordable housing finance more available through consumer education activities, 
outreach efforts, and special products. 

By the same token, the estimates do not include such other benefits to the GSEs as the 
use of the book-entry system maintained by the Federal Reserve or the ability to issue 
securities without obtaining private rating-agency ratings. The estimates also credit the GSEs 
for passing through lower rates on all the mortgages they purchase (including adjustable-rate 
mortgages and multifamily mortgages), not just on fixed-rate mortgages'^. And the estimates 
do not include any additional competitive advantage that may result from government 

sponsorship. 

• 

Nevertheless, these estimates do provide a foundation for assessing how Fannie Mae 
and Freddie Mac work within the overall secondary mortgage market. 



" The GSEs' combined 1995 pre-tax net income (including Fannie Mae's special contribution to its 
foundation) was $4.9 billion. 

'* We estimate that for single-family mortgages originated in 1994, the GSEs financed 83 percent of the 
conforming, conventional fixed-rate mortgages and 17 percent of the conforming, conventional adjustable- 
rate mortgages. The fully private sector financed 17 percent of the fixed-rate and 83 percent of the 
adjustable-rate conforming, conventional mortgages originated that year. 



36 

C. The GSB^' Current Business Operations and PRonTABiLiTY 

Although valuing the benefits of government sponsorship involves uncertainties, our 
estimates suggest that those benefits are substantial, a conclusion consistent with a basic review 
of the financial performance of Fannie Mae and Freddie Mac. In addition to enabling the 
GSEs to fulfill their public purpose, government sponsorship appears to shape their operations 
and opportunities in significant ways. 

1. Mortgages Outstanding 

Fannie Mae and Freddie Mac are two of the largest financial companies in the United 
States. Table II. 1 shows each GSE's outstanding mortgage-backed securities and retained 
portfolio from 1989 through 1995. At the end of 1995, the two GSEs held some or all of the 
credit risk for more than $1.3 trillion in mortgages — 34 percent of the $3.9 trillion in total 
outstanding residential mortgage debt in the country and 2.7 times the $491 billion of 
mortgages and mortgage-backed securities held by OTS-regulated savings associations. 
Furthermore, the $360 billion combined retained portfolio of Fannie Mae and Freddie Mac is 
just slightly less than the $365 billion of single-family mortgages held by all OTS-regulated 
savings associations. 

Since 1989, the two GSEs have almost doubled their outstanding mortgage-backed 
securities and nearly tripled their retained portfolios. Much of this growth has occurred in 
recent years. 



37 



Table II. 1: Mortg a ges Seciiritized and Retained in Portfolio by Fannie Mae and Freddie Mac, 
1989 to 1995 
(Dollars in billions) 





Fannie Mae 


Freddie Mac 


( 


Combined 


MBS' 


Retained 
Portfolio 


Total 


MBS' 


Retained 
Portfolio 


Total 


MBS' 


Retained 
Portfolio 


Total 


1989 


$217 


$108 


$324 


$273 


$21 


$294 


$490 


$129 


$618 


1990 


288 


114 


402 


316 


21 


338 


604 


135 


740 


1991 


355 


126 


482 


359 


27 


386 


714 


153 


868 


1992 


424 


156 


581 


408 


34 


441 


832 


190 


1,022 


1993 


471 


190 


661 


439 


56 


495 


910 


246 


1,156 


1994 


486 


221 


707 


461 


72 


533 


947 


293 


1,240 


1995 


513 


253 


766 


459 


107 


566 


972 


360 


1,332 



Note: Totals may not add due to rounding. 

Source: Fannie Mae and Freddie Mac Annual Reports and Investor/Analyst Reports 

' Mortgage-backed securities (MBS) do not include those issued by the GSE but held in its own portfolio. 
The retained portfolio category includes those mortgage-backed securities retained by the GSE. 



2. Sources of Income, and Growth of Retained Poilfolio 



The importance of the GSEs' retained portfolios is illustrated in Table II. 2, which 
shows that net interest income accounted for more than two-thirds of Fannie Mae's total 
revenue in recent years. For Freddie Mac, net interest income increased from about 39 
percent in 1992 to over 55 percent by 1995.'^ Fee income from guaranteeing mortgage- 



" A better standard for gauging the importance of different business activities would be percent of net 
income by income source. Considering only total revenue by income source ignores the allocation of costs 
among various business activities. For example, managing the interest rate risk associated with the 
retained portfolio of Fannie Mae and Freddie Mac may require greater resources than managing the credit 
risk associated with the outstanding portfolio of mortgage-backed securities. Fannie Mae reports statistics 
similar to Table 2.2 based on net income by line of business. In 1995 (before special contributions to the 
Fannie Mae Foundation), portfolio investment made up 57.7 percent of net income, credit guarantees made 
up 40.8 percent, and fee-based services made up 1.4 percent. Freddie Mac only recently (first quarter of 
1996) adopted reporting practices that allow calculations of the percent of net income by income source, 
and it told us that this information was not publicly available for previous time periods. 



38 

backed securities still makes up a substantial portion of total income but may diminish in 
importance if Fannie Mae and Freddie Mac pursue portfolio growth as the key to expanding 
profits. Other income, consisting primarily of REMIC fees, tends to fluctuate greatly from 
year to year in response to originations and investor demand for these products. 



Table II. 2: Fannie Mae and Freddie Mac Percentages of Total Revenue by Sources of Income 



in percentage points) 












1995 


1994 


1993 


1992 


Fannie Mae 










Net Interest Income 


72.2 


69.7 


67.5 


67.3 


Guarantee Fee Income 


25.7 


26.7 


25.6 


27.3 


Other Fee Income 


2.1 


3.6 


6.9 


5.5 


Freddie Mac 










Net Interest Income 


55.6 


48.6 


40.4 


38.9 


Guarantee Fee Income 


43.1 


48.5 


52.9 


57.6 


Other Fee Income 


1.5 


2.9 


6.7 


3.5 



Source: Fannie Mae and Freddie Mac Investor/Analyst Reports 



Table II. 3 presents summary statistics that indicate the GSEs' increased focus on 
building their retained portfolio. For both Fannie Mae and Freddie Mac, the retained portfolio 
growth rate in recent years has exceeded the outstanding mortgage-backed securities growth 
rate. The growth in Freddie Mac's retained portfolio is especially marked. In 1995, that 
portfolio grew by 48.6 percent while outstanding mortgage-backed securities decreased. Since 
1992, retained portfolio as a share of total mortgages acquired has continually increased for 
Fannie Mae and more than doubled for Freddie Mac. 



39 



Table II. 3: Increased Focus on Retained Portfolio hy Fannie Mae and Freddie Mac 
(in percentage points) 





1995 


1994 


1993 


1992 


Fannie Mae 










Retained portfolio annual 
growth rate' 


14.5 


16.1 


21.7 


23.4 


Outstanding mortgage-backed 
securities annual growth rate 


5.5 


3.2 


11.0 


19.5 


Retained portfolio as a share 
of total mortgages acquired 


33.0 


31.2 


28.7 


26.9 


Freddie Mac 










Retained portfolio annual 
growth rate ' 


48.6 


28.7 


66.3 


26.3 


Outstanding mortgage-backed 
securities annual growth rate 


-0.003 


4.9 


7.7 


13.5 


Retained portfolio as a share 
of total mortgages acquired 


19.0 


13.6 


11.3 


7.6 



Sources: Fannie Mae and Freddie Mac Fourth Quarter, 1995 Investor/Analyst Report and Annual 
Reports. 

' Retained mortgage portfolio includes mortgage-backed securities and REMICs held in portfolio. 



Why have Fannie Mae and Freddie Mac continually expanded their retained mortgage 
portfolios? There are at least two possible explanations. First, holding mortgages in portfolio 
may represent the optimal profit maximizing strategy for the GSEs based on current market 
conditions. As described earlier in this chapter, government sponsorship gives Fannie Mae 
and Freddie Mac significant advantages over other lenders that hold mortgages in portfolio. 

Second, increasing their retained mortgage portfolios may better serve the GSEs' public 
purpose by enabling them to develop new products or provide enhanced stability to the 
mortgage market. However, new product development could be achieved with a much smaller 
retained mortgage portfolio. 



40 

The recent history of Freddie Mac suggests that the former explanation rather than the 
latter may better explain the growth in its retained mortgage portfolio. Before 1989, the thrift 
industry held Freddie Mac's stock and Freddie Mac securitized almost all the mortgages it 
purchased. By all accounts, Freddie Mac succeeded in accomplishing its mission of 
developing a liquid secondary market. Freddie Mac began to pursue an aggressive strategy of 
building its retained portfolio after Congress changed its corporate structure in 1989 to one 
resembling Fannie Mae's. 

3. The Prontability of Fannie Mae and Freddie Mac 

The special benefits of GSE status outlined earlier in this chapter have not only aided 
Fannie Mae and Freddie Mac in fulfilling their mission of developing a secondary market, but 
also helped them dominate certain sectors of the mortgage market, contributing to their 
profitability. Table II. 4 compares the after-tax returns on equity for Fannie Mae, Freddie 
Mac, other financial firms, and the market return as measured by the S&P 500.'^ By this 
measure, Fannie Mae and Freddie Mac have outperformed much of the market. The 
comparison suggests that, if other market participants are earning normal profits, Fannie Mae 
and Freddie Mac are earning above-normal (i.e., economic) profits.'^ Hermalin and Jaffee 
(1996, pp. 250-253) discuss other measures of economic performance that support the 
conclusion that Fannie Mae and Freddie Mac earn above-normal market returns. One 
explanation for such added profits is the cumulative effect of the subsidies the enterprises 
receive from their government sponsorship. Another explanation is the efficiency of the two 
enterprises, perhaps aided by economies of scale in their operations. 



'* It should be noted that the average return on equity for the S&P 500 in Table II. 4 is pre-tax and the 
other measures are after-tax. Thus, if the S&P 500 measure were measured on an after-tax basis, the 
performance of Fannie Mae and Freddie Mac relative to the market would be even better. 

" Higher returns to equity do not necessarily imply excess or economic profits if the business risks are 
greater. However, given that Fannie Mae and Freddie Mac have had relatively stable returns on equity 
and consistendy lower credit losses than other mortgage lenders, and tliat their mortgage-backed securities 
and debt securities receive preferential regulatory treatment, it would seem implausible that the return on 
equity differentials from Table II. 4 could be explained by risk. 



41 



Table II.4: Comparis ons of After-Tax Return on Hqiiity 



(in percentage points) 
















1995 


1994 


1993 


1992 


1991 


1990 


Fannie Mae 


23.1' 


24.3 


25.3 


26.5 


27.7 


33.9 


Freddie Mac^ 


21.9 


23.2 


22.2 


21.2 


23.6 


20.4 


FDIC-Insured 
Commercial Banks 


14.7 


14.6 


15.3 


13.0 


7.9 


7.5 


FDIC-Insured Savings 
Institutions 


9.4 


8.3 


9.2 


9.5 


1.3 


-6.7 


S&P 500^ 


NA 


19.3 


14.6 


12.6 


10.3 


14.2 


S&P Financial 
Composite^ 


NA 


NA 


13.5 


10.5 


9.4 


9.2 



Source: Fannie Mae Annual Reports, Fannie Mae Investor/Analyst Report, Freddie Mac Annual Reports, 
Freddie Mac Investor/ Analyst Report, FDIC Quarterly Banking Profile, and Standard and Poors (1995). 

' The 1995 return on equity for Fannie Mae does not include the special $227.5 million after-tax 

contribution Fannie Mae made to the Fannie Mae Foundation. If this contribution were included, the 1995 

return on equity would have been 20.9 percent. 

^Freddie Mac's returns are on common equity. 

' S&P returns are pre-tax and based on book values. S&P 500 returns for 1995 and S&P financial 

composite returns for 1995 and 1994 are not currently available. 



D. 



Summary 



Fannie Mae and Freddie Mac contribute liquidity to the secondary mortgage market 
through their two primary business activities: securitizing mortgages, and purchasing and 
funding mortgages for their own portfolios. The enterprises' government sponsorship provides 
specific benefits that lower their operating costs or make their securities more liquid or more 
attractive to investors. Investors accord their debt securities and mortgage-backed securities 
preferential treatment because of a perception that the federal government implicitly guarantees 
those securities, even though the securities specifically disclaim any government guarantee. 
The principal constraint on the GSEs is that their federal charters restrict their business 
operations to supporting the secondary mortgage market. And the GSEs must satisfy 
regulatory requirements that promote affordable housing. 



42 

Fannie Mae and Freddie Mac perform a valuable function in our nation's housing 
markets at no explicit budgetary cost to the taxpayers. The government benefits granted to the 
GSEs do, however, have a real, uncompensated opportunity cost. A baseline estimate suggests 
that these benefits amounted to almost $6 billion last year. Based on estimates that the GSEs 
lower mortgage interest rates on conforming, conventional fixed-rate mortgages by 20 to 40 
basis points, the GSEs provided benefits to home buyers of $2.6 billion to $5. 1 billion. A 
midpoint (baseline) estimate of the benefits provided to home buyers is about $4 billion. 
While no point estimate can avoid uncertainty in measuring governmental benefits received 
and public benefits conferred, estimates such as these convey a general order of magnitude for 
considering the value of the subsidies involved. 

Despite constraining their business activities, GSE status has helped make Fannie Mae 
and Freddie Mac large and profitable. Together, at the end of 1995, their retained portfolio 
and outstanding mortgage-backed securities exceeded $1.3 trillion, which was 2.7 times more 
than the entire OTS-regulated thrift industry's holdings of mortgages and mortgage-backed 
securities. A comparison of the GSEs' profitability to other firms suggests that GSE benefits 
enabled Fannie Mae's and Freddie Mac's shareholders to earn increased profits. 



43 
CHAPTER m 

THE GSES' PUBLIC PURPOSE 



Traditionally, the government has established GSEs when it perceives the need to 
correct a specific market failure. For example, Congress created the Farm Credit System, a 
cooperative lending system, in 1916 to help make credit more available for farmers. 
Similarly, Fannie Mae was created in 1938 to help establish a secondary market for the new 
federally guaranteed home mortgage loans and to reinvigorate a housing finance market that 
the Great Depression had brought to the brink of collapse. However, both capital markets and 
financial institutions have changed dramatically since that time, making it appropriate for 
Congress to periodically evaluate whether and on what basis government sponsorship remains 
justified. 

In this chapter, we consider two ways in which Fannie Mae and Freddie Mac advance 
public policy. The first is by participating in the secondary market for residential mortgages, 
the purpose for which Congress originally established them. The second is by carrying out the 
series of affordable housing initiatives directed by Congress in 1992. In each case, we 
compare the efforts of Fannie Mae and Freddie Mac with those of private financial 
institutions. 

A. The Current Structure of the Housing Finance Market 

Before we can assess the private market characteristics that may or may not make 
continued government sponsorship desirable, we need to review the current characteristics of 
the mortgage market. 

We focus our research here and in the rest of the chapter on the single-family mortgage 
market because that is where Fannie Mae and Freddie Mac are most active. In 1994, the two 
GSEs purchased approximately 57 percent of single-family conforming, conventional 
mortgages, compared with only 14 percent of multifamily originations.' We recognize, 
however, that multifamily loans represent a relatively large share of the GSEs' affordable 
housing loans, which are described in more detail in Section B.^ 



' Of the two GSEs, Fannie Mae is much more active in the multifamily market. Freddie Mac left the 
multifamily market in the early 1990s because of sustained losses, but has recently re-entered the market. 

^ HUD (1996-C) also comments on the limited role Fannie Mae and Freddie Mac currently play in 
financing multifamily housing. In addition, Wachter et. al. (1996, p. 366) conclude that concerns about 
multifamily finance should not be determinative in evaluating the merits of ending the two GSEs' 
government sponsorship. 



44 

Government involvement has helped create some clear dividing lines in today's 
mortgage market. Table III. 1 shows the dollar value of single-family mortgage originations in 
1994 for both conforming and non-conforming loans. The table also divides the conforming 
mortgage market into four segments: (1) the FHA/VA market (with the vast majority of these 
loans guaranteed by Ginnie Mae); (2) Fannie Mae purchases; (3) Freddie Mac purchases; and 
(4) loans not sold in the government-sponsored secondary market. 



Table III.l: Distribution of Single-Family Mortgage Loan Originat ions. 1994 
(Dollars in billions) 





Volume 


Share 


Conforming Loans' 


$643.6 


84% 


FHA/VA 


$143.1 


19% 


Fannie Mae Purchases 


$162.5 


21% 


Freddie Mac Purchases 


$123.4 


16% 


Loans not Sold in the Government 
Sponsored Secondary Market^ 


$214.6 


28% 


Non-conforming Loans^ 


$125.1 


16% 


Total 


$768.7 


100% 



Source: HUD (1996-D) and Mortgage Market Statistical Annual for 1995. 

' Conforming loans are defined as loans below the conforming loan limit of $203,150 in 1994. 

^ Conforming loans not sold in the government sponsored secondary market include adjustable rate 

mortgages, affordable housing mortgages, and B-C credit mortgages. 

' The estimate for originations of non-conforming loans is obtained from Inside Mortgage Finance, 

assuming that non-conforming loans account for 20 percent of the conventional (non-FHA/VA) market. 

HUD (1995-B) reports a similar estimate of 19 percent for the share of non-conforming loans in the 

conventional market. 



The Fannie Mae/Freddie Mac portion of the conforming loan market is commonly 
referred to as the A credit market. Conventional mortgages that do not meet the two GSEs' 
underwriting standards include certain affordable housing loans and the small but growing 
portion of the conventional mortgage market made up of B and C credit loans - loans made to 
borrowers with credit history problems. 



45 

Loans not sold into the government-sponsored secondary market may be held in 
portfolio by financial institutions, securitized by private-sector secondary-market companies, 
or held by individuals or other investors. Financial institutions' portfolio holdings also include 
adjustable rate mortgages and mortgages that do not meet the two GSEs' underwriting 
standards. 

B. System- Wide Imperfections in the Housing Finance Market 

The financial system generally, and the housing finance system in particular, have 
undergone enormous change since the creation of Fannie Mae and Freddie Mac. Today's 
housing finance market does not suffer from the problems that prevailed thirty years ago. 

Regulatory and statutory factors that contributed to inefficiency in this market are no 
longer an issue. In the early 1980s, the federal government phased out Regulation Q and 
permitted depository institutions to offer adjustable rate mortgages, which addressed the 
fundamental problem of funding long-term assets with short-term liabilities. In 1994, 
Congress repealed restrictions on interstate banking and branching that had long inhibited 
geographic diversification. 

Mortgage securitization, which began with Ginnie Mae's creation of the first mortgage- 
backed security, has also made the mortgage market more liquid and linked it to the capital 
markets. Ginnie Mae, Fannie Mae, and Freddie Mac have each contributed to the growth of 
mortgage securitization. Fully private institutions have successfully replicated these efforts. 
Other segments of the mortgage market and the asset-backed security market demonstrate the 
ability of today's capital markets and private financial institutions to maintain liquid secondary 
markets without government support. In addition, the sheer size of the mortgage market, 
together with the participation of large national and regional firms, gives the market substantial 
stability. 

1. The Capability of the Private Sector Secondary Market 

One way to assess the private sector's ability to perform the secondary market function 
currently undertaken by Fannie Mae and Freddie Mac is to look at the development of other 
secondary mortgage markets and at overall trends in asset securitization. This helps provide a 
sense of the extent to which other financial markets have developed and the private sector's 
capacity to sustain a secondary market. 

Today a wide array of financial assets - from credit card receivables to aircraft leases 
- are securitized without GSE or other government support. Financial institutions - such as 
commercial banks, investment banks, private mortgage insurers, mortgage banks, and finance 
companies - have worked together in developing these markets, which have grown 
dramatically over the past decade. These secondary markets share at least two common 
characteristics. First, somewhat uniform underwriting standards are necessary for rapid 



46 

market development, since individual assets (i.e., loans) must be combined into one security. 
Second, credit rating agencies must be able to evaluate the credit risk of the pool of assets 
underlying the publicly issued securities. 

Secondary markets for jumbo/non-conforming and B-C (lower credit quality) 
mortgages are well developed. Table III. 2 compares the securitization rates in the non- 
conforming market and the conventional, conforming market.^ These two segments of the 
conventional secondary mortgage market have very different market structures. The 
conventional, conforming secondary market for A-credit mortgages, consisting of Fannie Mae 
and Freddie Mac, is what economists call a duopoly.* By contrast, during 1994 the 
jumbo/non-conforming market had 37 active corporate participants, 16 of which issued over 
$1 billion of private-label mortgage-backed securities. The three largest companies were GE 
Capital Mortgage Services ($10.5 billion issued). Prudential Home MSCI ($7.2 billion issued), 
and Countrywide/CWMBS ($5 billion issued).^ 

The annual securitization rates in Table III. 2 (calculated by dividing the mortgage- 
backed securities issued by the estimated dollar value of mortgages originated in each market) 
provide an estimate of how much of the business volume the secondary market securitizes. 



' The jumbo/non-conforming market consists primarily of loans above the conforming loan limit but the 
available data may include a small proportion of loans below the conforming loan limit that do not meet the 
underwriting standards of Fannie Mae and Freddie Mac. 

* See Hermalin and Jaffee (1996) for a technical description of how Fannie Mae and Freddie Mac 
constitute a duopoly in their market and the characteristics of various types of duopoly market structures. 

* Complete historical statistics on the private label mortgage-backed securities market can be found in the 
Mortgage Market Statistical Annual for 1995. 



47 



Table III.2: Comparison of Mortgage-Back ed Securities Issued and Securitization Rates for 
Conforming and Jumbo Mortg a g es' 
(Dollars in billions) 





Non-FHA/VA Conforming Loans 


Jumbo/Non-Conforming Loans^ 


Year 


MBS Issuance^ 


Securitization Rate 


MBS Issuance' 


Securitization Rate 


1989 


$142.6 


47.2% 


$14.2 


15.7% 


1990 


$170.5 


57.6% 


$24.4 


26.6% 


1991 


$205.4 


53.0% 


$39.8 


35.4% 


1992 


$372.4 


58.2% 


$74.4 


41.6% 


1993 


$430.2 


62.6% 


$97.3 


48.2% 


1994 


$247.7 


51.9% 


$62.9 


46.3% 



Source: Mortgage Market Statistical Annual for 1995 (pp. 161-62). 

' Conventional (non FHA/VA) conforming originations and jumbo/non-conforming originations are 
estimated by Inside Mortgage Finance. The starting point is data from HUD on the dollar value of total 
originations, from which FHA/VA origination dollar volume is subtracted to obtain conventional 
originations. A 20 percent rule is applied to the dollar volume of conventional originations to calculate the 
dollar share of the jumbo/non-conforming market. This estimate was based on a 1990 National 
Association of Realtors Survey and has recently received support from HMD A data. HUD (1995-B) 
reports a similar estimate of 19 percent for the dollar share of non-conforming loans in conventional 
market originations. 

^ The jumbo/non-conforming private label issues of mortgage-backed securities include some conforming 
loans that do not meet the underwriting standards of Fannie Mae and Freddie Mac. Since this is a small 
portion of the market the 20 percent estimate for originations would not be changed substantially and the 
same general trend pattern would be evident. 

' Virtually all securitized conforming loans were securitized by the GSEs. Securitization rates do not 
include mortgages sold in the secondary market to the GSEs or another entity that were not pooled and 
resold as mortgage-backed securities. 



The securitization rate for jumbo/non-conforming mortgages increased from 
approximately 15 percent of originations in 1989 to almost 50 percent by 1994. By contrast, 
the securitization rate for non-FHA/VA conforming loans varied between 47 percent and 62 
percent during this period. The rapid growth of secondary market activity in the jumbo/non- 
conforming market reflects the private sector's growing ability to operate a liquid secondary 



48 

market. That such growth occurred while home prices were weak in the regions with the 
largest concentration of jumbo loans -- the Northeast and California -- suggests that the private 
secondary market can operate despite difficult economic circumstances. 

Primary lenders searching for profitable market opportunities have increased 
originations of B-C loans made to higher risk borrowers — most of whom have a history of 
significant credit problems -- spurring the development of a secondary market for these loans. 
Unlike jumbo mortgages, which Fannie Mae and Freddie Mac cannot legally purchase, B-C 
loans stretch underwriting criteria beyond the limits currently acceptable to Fannie Mae and 
Freddie Mac. (The GSEs' charters limit them to purchasing investment grade loans.) Figure 
III. 1 presents estimates for securitization rates in the B-C market and projections through the 
year 2000. The B-C secondary market has grown from virtually nothing in 1988 to 
approximately 10 percent to 15 percent of B-C originations in 1995. '' 



Figure ITI.l: Share of Total Non-Conforming and B-C Credit Closed-End TFixed 
Amortization Schedule) Mortgage Originations Securitized 



25.0% 



20.0% -- 



15.0% 



10.0% 



5.0% 



0.0% 



.iiitiilniJ 



1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 



Source: Historical data (1989-1995) are from Asset Sales Report (New York, New York). Projections 
from 1996 to 2000 are by David Olson Research (Columbia, Maryland). 



* Estimates of the securitization rate in the B-C credit market may vary by what is included in the B-C 
origination pool. The Mortgage Market Statistical Annual for 1995 (p. 350) reports a securitization rate of 
14.9 percent in 1994. 



49 

Surveys by America's Community Bankers have also documented increased activity in 
the jumbo and B-C credit markets. Private secondary market organizations accounted for 
approximately 32 percent of the dollar volume of secondary market loan sales by thrifts in a 
1994-95 survey, up from 28 percent in the 1993-94 survey and 17 percent in 1992-93. In 
1994-95, private conduits bought 1 1 percent of the dollar volume of thrifts' originations sold 
in the secondary market, surpassing Freddie Mac (at about 10 percent), for the first time. 

As indicated earlier, the private sector has recently also developed secondary markets in 
other financial instruments. Table III. 3 compares the percentages of outstanding debt in the 
home mortgage market with that in other securitized financial markets. (A better measure 
would be the securitization rate as presented in Table III. 2, but data on originations in some of 
these asset categories are not available.^) While the percentages of outstanding debt that have 
been securitized in other financial markets remain below that in the home mortgage market, 
they have grown rapidly since 1989. These other markets are still relatively young, and 
standardization of the underlying assets may never reach the degree of uniformity of certain 
other segments of the home mortgage market. 



' The securitization rate is a flow variable measuring the amount of originations that are transformed into 
another security in a given year. The percentage of outstanding debt that has been securitized measures 
the outstanding stock of asset-backed securities relative to outstanding stock of debt at a given time. 



50 



Table III. 3: Share of Home Mortgage, Revolving Credi 


t. Automobile, and Commercial Real 


Estate Debt Securitized 

(Percentage of total debt outstanding) 




1989 


1990 


1991 


1992 


1993 


1994 


1995^ 


Home Mortgage Debt 
(1-4 Family)' 


36.8 


39.9 


43.7 


46.6 


47.5 


48.7 


48.4 


Revolving Credit 


11.2 


19.1 


24.5 


27.6 


26.5 


26.8 


30.5 


Automobile Credit 


6.3 


8.6 


11.0 


13.1 


14.0 


11.0 


11.0 


Commercial Real Estate 


0.6 


0.7 


0.9 


2.1 


3.6 


5.2 


5.3 



Source: Federal Reserve Board (1995-A), Federal Reserve Bulletin (various issues, Table 1.55) 

' The calculation of outstanding MBS for this category is obtained by adding Flow of Funds outstanding 
levels for federally related home mortgage pools (Ginnie Mae, Fannie Mae, and Freddie Mac) to the 
private label issuance of MBS recorded in the Flow of Funds. 
^ Shares for 1995 are calculated through the end of the second quarter. 



Securitization of commercial real estate loans, small business loans, and distressed 
assets has also become more common. Table III. 3 shows that the percentage of outstanding 
securitized commercial real estate debt has increased from under 1 percent in 1989 to over 5 
percent in 1995. Small business asset-backed securities are also being issued, although they 
still account for less than 1 percent of outstanding small business debt.* According to Fabozzi 
and Modigliani (1992, p. 312), asset-backed securities based on boat loans, recreational 
vehicle loans, computer leases, senior bank loans, and accounts receivable have also appeared 
in the market. 

These rapidly growing secondary markets - operating without government sponsorship 
— are more competitive and involve loans with more diverse credit quality and borrower 
characteristics than the A-credit mortgages Fannie Mae and Freddie Mac purchase. Numerous 
firms of varying size vie for profitable business, with large market leaders like GE Capital, 
Countrywide, and Citicorp assuming prominent roles in the financial system and mortgage 
markets. The success of these markets suggests that Fannie Mae, Freddie Mac, and other 
firms may be able to adequately maintain liquid, regionally responsive secondary mortgage 
markets without government sponsorship. 



For details on the small business market, see Feldman (1995). 



51 

Given the characteristics of secondary markets operating without government 
sponsorship, what explains the lack of direct competition to Fannie Mae and Freddie Mac in 
the conventional, conforming secondary market? One possible explanation is that the 
competitive advantage of GSE status, described in Chapter II, inhibits competitors from 
entering this market: the premium investors are willing to pay for GSE securities and the cost 
advantages of government sponsorship may enable the GSEs to price below the level at which 
potential competitors find it profitable to enter the market. 

Another possible explanation for the lack of direct competition to Fannie Mae and 
Freddie Mac involves possible economies of scale in their business operations, and an 
attendant cost structure low enough so that other firms do not find it profitable to enter the 
market. Economies of scale exist where average total costs (per unit) decline as output 
increases. But such economies seem an unlikely explanation here because other segments of 
the mortgage market do not have a highly concentrated market structure. 

If, however, economies of scale did explain the lack of direct competition to Fannie 
Mae and Freddie Mac, ending government sponsorship need not affect their market share or 
mortgage rates. Even without such sponsorship, the two firms' favorable cost structure would 
probably enable them to compete effectively in the secondary market. Any economic benefits 
resulting from economies of scale that accrue to certain borrowers would continue, and 
borrowers in other segments of the market could also benefit if restrictions on other activities 
were lifted.' 

2. Withstanding Tight Credit Markets 

Another concern warranting attention is whether a secondary market without GSE 
support would excessively retreat from funding mortgages when credit is tight.'" The overall 
size of the mortgage market, the number and size of national and regional participants in 
various aspects of that market, and the technical capability to link that market with the capital 
markets should mitigate this concern. • 

As illustrated by Table III. 4, home mortgage debt outstanding falls only slightly short 
of outstanding publicly held U.S. Treasury securities. In 1995, the mortgage-backed securities 
market was: just under 50 percent of the size of the U.S. Treasury security market; almost 65 
percent of the size of the private bond market; and considerably larger than the tax-exempt and 



' Any resulting market structure that has a small number of firms, even if this is the result of economies of 
scale, should be evaluated for possible anti-competitive issues. 

'" Some studies have questioned whether the GSEs have been able to exert a significant counter-cyclical 
impact. For example, Kaufman (1988) provides evidence that the counter-cyclical impact provided by 
Fannie Mae diminished in the eighties as a result of changes in the financial system and their operating 
procedures. 



52 

open market (commercial) paper markets. These other large financial markets suggest that 
government sponsorship is not necessary to promote active, liquid markets. 



Table III. 4: Size of Home Mortgage Market Relative to Other Financial Markets 



(Billions of dollars of debt outstanding, year end) 












1989 


1990 


1991 


1992 


1993 


1994 


1995' 


U.S. Treasury Securities 
(publicly held) 


2227.0 


2465.8 


2757.8 


3061.6 


3309.9 


3465.6 


3556.7 


Total Home Mortgage 
Debt (1-4 Family) 


2407.8 


2616.3 


2780.0 


2959.6 


3149.6 


3344.8 


3431.8 


Corporate and Foreign 
Bonds 


1581.3 


1695.8 


1856.3 


2026.4 


2301.5 


2438.4 


2568.9 


Securitized Home 
Mortgage Debt' 


885.6 


1043.7 


1214.4 


1380.2 


1497.2 


1628.9 


1660.1 


Tax Exempt Securities 
and Loans 


991.2 


1039.9 


1108.6 


1139.7 


1215.2 


1185.2 


1164.6 


Open Market Paper 


579.2 


609.9 


565.9 


579.0 


580.0 


623.5 


673.8 



Source: Federal Reserve Board. (1995-A). 

' Securitized home mortgage debt is a subset of total mortgage debt. The calculation of securitized home 
mortgage debt (1-4 family) is obtained by adding Flow of Funds outstanding levels for federally related 
home mortgage pools (Ginnie Mae, Fannie Mae and Freddie Mac) to the private label issuance of MBS 
recorded in the Flow of Funds. 
^ Debt outstanding for 1995 is through the end of the second quarter. 



The mortgage market derives stability not only from its large size but from the many 
national and regional mortgage originators, servicers, and insurers operating over broad 
geographical regions and devoting significant capital to market development. In 1994, eight 
companies exceeded $10 billion in origination volume, ten companies exceeded $50 billion in 
servicing volume, and six companies exceeded $10 billion in mortgage insurance volume." 



" The top eight mortgage originators in 1994 were Countrywide, Norwest, Prudential, Chase Manhattan, 
Chemical, Fleet, GE Capital, and GMAC. The top ten mortgage servicers in 1994 were Countrywide, GE 
Capital, Fleet, Prudential, Norwe.st, Chase Manhattan, GMAC, Chemical, Bank of America, and Home 
Savings of America. The top six private mortgage in.surers in 1994 were GE Capital, Mortgage Guaranty 
Insurance Corporation, PMI Mortgage Insurance Company, United Guaranty Corporation, Republic 



53 

Having made the enormous commitments -- of capital, workforce development, and 
technological resources — needed to compete in the residential mortgage market, firms with a 
primary business in that market are unlikely to abandon it when faced with cyclical downturns. 
While such cyclical fluctuations may deter marginal firms, those invested in the market for the 
long-term will seek to preserve or even build their market share. 

3. Weathering Regional Economic Downturns 

Another concern for policymakers is the mortgage market's ability to weather regional 
fluctuations. Fannie Mae and Freddie Mac often use the phrase "being in all markets at all 
times" to refer to their capability to provide liquidity to regional housing finance markets 
during regional economic downturns. Although the GSEs' charters do not establish any 
specific requirement to operate in all markets at all times, the charters do suggest a 
responsibility to maintain a nationwide presence. 

In the past, technological and informational constraints, limits on interstate banking and 
branching by insured depository institutions, and other aspects of our financial system 
constrained mortgage credit flows across regions. Today, however, these problems have faded 
as regulatory and market changes have greatly enhanced credit flows. Investors, originators, 
and private mortgage insurance companies can now diversify regional risk in the secondary 
market. 

By statute, OFHEO must prescribe a stress test that increases the amount of capital 
required for a given book of business as economic conditions worsen.'^ If the GSEs continue 
to operate at or near their regulatory minimum capital requirements, their ability to maintain or 
expand purchasing activity during a general or regional economic downturn could be limited.' 

Similarly, while the GSEs may continually offer to purchase mortgages, even from 
distressed regions, their pricing may reflect risk differentials. Each GSE offers a "posted 
price" at which it will purchase any qualifying mortgage. However, the GSEs make the bulk 
of their mortgage purchases using negotiated prices, which are generally less than the posted 



Mortgage Insurance Company, and Commonwealth Mortgage Assurance Company. The Mortgage 
Market Statistical Annual for 1995 contains complete details on market share rankings. 

'^ The OFHEO sU-ess test, by law, initially assumes that the GSEs take on no new business once the "stress 
period" begins [P.L. 102-550, Sec. 1361(a)(3)(A)]. Thus, it does not assume that the GSEs will continue 
to provide liquidity during a period of severe market stress. On the contrary, it assumes they will do no 
new business. 

" "[OFHEO's] risk-based capital standard, which will be based on a stress test approach, will 
automatically respond to changes in either of the Enterprises' future risk profile. For example, if house 
prices fall, causing homeowners to have less equity in their properties and increasing the probability of 
their defaulting in the future, this will be immediately reflected in higher capital requirements." (OFHEO, 
1996-B, p.4.) 



54 

price. Negotiated prices would presumably be adjusted to reflect changing risk characteristics 
of the underlying loans. Furthermore, any mortgage purchases made by a GSE in a distressed 
region or during an economic downturn must still satisfy the GSEs' underwriting standards. 
For example, mortgages with loan-to-value ratios exceeding 80 percent must have private 
mortgage insurance. 

C. Affordable Housing Needs 

How does the ability of Fannie Mae and Freddie Mac to finance affordable housing 
compare to that of other private market participants and existing government agencies? In the 
1992 Act, Congress expanded the two GSEs' public purpose to include explicit requirements 
that the secondary mortgage market adequately serve underserved segments of the mortgage 
market, making affordable housing an additional topic for consideration when evaluating GSE 
status. The government has encouraged numerous initiatives to promote the flow of credit to 
underserved borrowers and communities and, as set forth in HUD's recent report. The 
National Homeownership Strategy: Partners in the American Dream (1995-A), an important 
government role in this mission still exists. Comparing the GSEs' achievements to certain 
affordable housing goals and the activities of other mortgage market participants provides 
insight into the value of GSE status to the public purpose of affordable housing. 

1. The GSI^' Achievement of HUD's Affordable Housing Goals 

One measure of the GSEs' contributions to affordable housing is their performance 
under affordable housing goals established by HUD.'"* Charged by Congress with ensuring 
that Fannie Mae and Freddie Mac meet their affordable housing requirements and the unmet 
needs of credit markets and underserved borrowers, HUD imposes housing goals based on the 
percentage of loans purchased from various types of targeted borrowers and communities.'^ 

This housing goal framework can help expand the GSEs' participation in financing 
affordable housing and meeting other unmet credit needs. HUD has implemented the goals 
consistently and fairly. The goals have the following advantageous characteristics: 

• The goals have a solid analytical and policy foundation. 



'* In the following discussion, affordable housing goals refer to all three housing goals even though the old 
central city goal and the new underserved area goal are not based on borrower income. 

'^ HUD was the primary regulator of Fannie Mae from 1968, and of Freddie Mac from 1989, until 1992, 
when Congress established OFHEO. HUD first issued affordable housing regulations for Fannie Mae in 
1978. 



55 

• The goals are broad-based performance standards that are easily understood, provide 
appropriate flexibility, and do not seek to fine-tune the GSEs' activities or otherwise 
interfere with their daily operations. 

• The goals can be used to target, to an important public purpose, the activities of the 
two dominant players in the conventional mortgage market. 

• HUD set the goals to cover a four-year period, at levels attainable under varying 
economic conditions, including higher interest rates and less favorable market 
conditions than those prevailing in 1993-95. 

• The goals represent reasonable benchmarks that the GSEs may exceed. They do not 
ratchet up or down based on annual changes in the GSEs' performance. 

Table III. 5 provides an overview of the goals and the GSEs' recent performance under 
the goals. In 1995, Fannie Mae satisfied all three interim housing goals, and Freddie Mac 
satisfied all but the central city goal. Fannie Mae's 1995 performance also exceeded all three 
of the goals that became effective in 1996, even at the fully phased-in levels that will apply in 
1997 and 1998. Freddie Mac's 1995 performance would have satisfied two of the final 1996 
goals, falling short (by less than a percentage point) only on the low- and moderate-income 
goal. The proportion of overall GSE activity meeting affordable housing goals has increased 
over the past few years, possibly due to the HUD goals and to CRA-driven increases in 
affordable housing lending generally and as a share of all mortgages originated. 



56 



Table III. 5: Overview of the GSFs' Affordable Hoiisii 


ig Goals and Performance 




(in percentage points) 










GoaP 


1993 


1994 


1995 


1996 Goals 


1997-1999 
Goals 


HUD'S Market 
Size Estimate 


Low- and Moderate Income 


Fannie Mae 


34.1 


45.1 


42.8 


40.0 


42.0 


48-52 


Freddie Mac 


30.0 


38.0 


39.6 








Geographic 


Fannie Mae 


22.9 


29.0 


31.2 


21.0 


24.0 


25-28 


Freddie Mac 


21.3 


24.2 


25.2 








Special Affordable 


Fannie Mae 


10.0 


16.7 


15.8 


12.0 


14.0 


20-23 


Freddie Mac 


7.2 


11.4 


13.2 









Source: HUD (1996- A, Table 3-2) 



' Percentages of dwelling units in properties whose mortgages were purchased by the GSEs that qualified 
for each goal in 1992-1995, and goals for 1996-1999. Performance has been measured based on the 
structure of the goals for 1996-1999. 
^Abbreviated definitions of the goals: 



Low-Mod: 
Geographic: 

Special Affordable: 



Households with incomes less than or equal to area median income (AMI). 
Metro census tracts with median income less than or equal to 120 percent of AMI. 
County definitions are used in non-metropolitan areas. 

Households with incomes less than or equal to 60 percent of AMI or less than or 
equal to 80 percent of AMI and located in low-income areas. 



In evaluating this progress, it is important to consider the characteristics of the loans 
that count toward the goals.'* For the most part, Fannie Mae and Freddie Mac met the central 
city housing goal by purchasing loans made to borrowers whose incomes exceeded the median 
MSA income. In 1994 (1995), for Fannie Mae, 55 percent (51 percent) of the loans purchased 



'* The following information on the characteristics of Fannie Mae's and Freddie Mac's loan purchases that 
satisfied the interim housing goals may be found in Fannie Mae (1996-A, 1995) and Freddie Mac (1996-A, 
1995). 



57 

that counted toward satisfying the interim central city goal had borrower income greater than 
100 percent of the median MSA income, and 42 percent (38 percent) had borrower income 
greater than 120 percent of the median MSA income. For Freddie Mac, 63 percent (59 
percent) of the loans purchased that counted toward satisfying the interim central city goal in 
1994 (1995) had borrower income greater than 100 percent, and 49 percent (46 percent) had 
borrower income greater than 120 percent of the median MSA income. 

The majority of loans that counted toward meeting the interim affordable housing goals 
had loan-to-value (LTV) ratios less than or equal to 80 percent ~ that is, mortgages made to 
borrowers who had made downpayments of at least 20 percent. In 1994, for Fannie Mae 
(Freddie Mac), loans with LTV ratios less than or equal to 80 percent made up 78 percent (79 
percent) of loan purchases that counted toward meeting the low-moderate income goal, 71 
percent (75 percent) that counted toward meeting the central city goal, and 73 percent (73 
percent) that counted toward meeting the special affordable goal. In 1995, the corresponding 
percentages for Fannie Mae decreased to approximately 64 percent, while Freddie Mac's 
percentages remained about the same. The predominance of low LTV loans — which have less 
credit risk than high LTV loans — suggests that the private sector could finance the majority of 
Fannie Mae's and Freddie Mac's affordable housing business. 

Beyond just meeting the HUD goals, the two GSEs have participated actively in 
expanding opportunities for affordable housing and in developing products and services to help 
meet the needs of low-income borrowers and communities. Fannie Mae, in particular, has 
made a clear commitment to provide educational materials and technical assistance to support 
the affordable housing activities of lenders. The GSEs have also increased their underwriting 
flexibility, improved homebuyer education programs, and entered into partnerships with local 
governments and non-profit organizations to provide additional affordable housing assistance. 
These secondary market developments may also reflect innovations by private mortgage 
insurance companies and other mortgage market participants. 

The GSE housing goals, combined with recent changes in underwriting standards and 
new mortgage products for affordable housing, may lead the two GSEs to further increase 
their affordable housing activities and serve a broader proportion of the affordable housing 
market than they have in the past. The GSEs could also become more active in financing 
multifamily mortgages, and in directly assisting homebuyers through affordable housing 
programs. We cannot project how the GSEs' contributions to affordable housing may change 
in the future since the GSEs already meet almost all of the housing goals. The GSEs' 
contribution to affordable housing should receive close examination as Congress considers the 
costs and benefits of their government sponsorship. 

Finally, another aspect of the 1992 legislation that also deserves examination in any 
evaluation of such sponsorship is the requirement that HUD oversee the GSEs' fair lending 
practices. While the GSEs would remain subject to the Fair Housing Act even without such 
sponsorship, the 1992 legislation authorized HUD to prescribe additional safeguards against 



58 

discriminatory lending practices. For example, HUD may review and comment on the GSEs' 
underwriting and appraisal guidelines, analyze the GSEs' business practices to ascertain 
whether those practices discriminate, and work with and through the GSEs to identify and 
remediate discriminatory practices by lenders. 

2. Affordable Housing Achievements: The GSEs Relative to the Market 

HUD's housing goals provide one measure of the GSEs' affordable housing 
performance. The relative share of the GSEs' mortgages that fund affordable housing 
compared to other mortgage market participants would be another way to assess the GSEs' role 
in mortgage lending for affordable housing. We evaluated the share of each secondary market 
participant's loan purchases that can be classified as affordable housing loans, and the 
distribution of affordable housing loans among all mortgage market participants. 

As described in the last section, regulators generally promote affordable housing 
finance by targeting borrower groups considered underserved by the market based on 
household income, race, location, or some combination of these characteristics. Income 
targets generally involve some comparison of borrower income to median MSA income." 
Geographic targets focus on the racial and income characteristics of various census tracts or on 
their classification as central city, urban, suburban, or rural. The remaining tables in this 
section use various categories of targeted borrowers that fit the typical definitions of 
underserved. 

a. Share of Business from Targeted Borrower Groups 

Table III. 6 summarizes each secondary mortgage market participant's loan purchases 
from selected targeted borrower groups. The percentages in Table III. 6 are averages of yearly 
shares. 



" Fannie Mae and Freddie Mac can satisfy the low- to moderate-income housing goal by purchasing loans 
with borrower income less than 100 percent of median MSA income. By contrast, for purposes of the 
Community Reinvestment Act (CRA) regulations recently established for FDIC-insured depository 
institutions, low- or moderate-income borrowers must have income that is less than 80 percent of median 
MSA income. 



59 



Table III. 6: Percentage of Secondary Market Participants' Loan Purchases From Targeted 


Borrower Groups 

(1991-94 averages of yearly shares, in percentage points) 




< 100% of 

Median MSA 

Income 


<80% of 

Median MSA 

Income 


Black 


Hispanic 


Census Tracts 

>80% 

Minority 


Low/Mod 

Income Census 

Tracts' 


Ginnie Mae^ 


54.1 


33.5 


8.8 


7.7 


3.6 


14.1 


Farmers Home 
Admin. 


48.7 


31.9 


4.2 


4.9 


3.2 


14.1 


Commercial Banks 


38.6 


23.9 


6.4 


4.6 


3.4 


10.8 


Other Purchasers' 


36.3 


22.6 


6.0 


5.3 


3.5 


11.0 


Life Insurance 
Companies 


35.4 


23.1 


8.1 


5.0 


2.3 


9.1 


Savings and Loans 


33.8 


19.1 


4.0 


3.3 


2.0 


9.3 


Fannie Mae 


29.7 


13.4 


2.7 


3.8 


2.3 


7.9 


Affiliates* 


29.4 


16.4 


4.1 


2.9 


1.9 


8.3 


Freddie Mac 


29.2 


13.1 


2.1 


3.9 


2 2 


8.0 



Source: HMDA Data summarized in Federal Reserve Board (I995-B, Table 4.41, p. A74), Canner and 
Passmore (1995-A), Canner, Fassmore and Smith (1994), and Canner and Smith (1992). 

' Low- or moderate-income census tracts are those in which median family income is less than 80 percent 

of the median family income of the MSA as a whole. 

^ Ginnie Mae does not actually securitize or purchase mortgages; it guarantees the timely payment of 

principal and interest on mortgage-backed securities consisting of FHA and VA mortgages. • 

' Other purchasers include investment banks, private companies that securitize mortgages, and pension 

funds. 

" Affiliates include companies affiliated with the institution reporting the loan. 



Table in.6 illustrates Ginnie Mae's clear lead in relative purchases of mortgages made 
to targeted borrower categories. This lead is not surprising given that FHA/VA loans - 
targeted at lower-income borrowers ~ represent the sole collateral for Ginnie Mae-guaranteed 



60 

mortgage-backed securities.'* Other secondary market participants generally make higher 
proportions of their loan purchases from targeted borrower groups than do Fannie Mae and 
Freddie Mac. For example, loans from borrowers earning less than 80 percent of median 
MSA income account for 33.5 percent of Ginnie Mae volume, but only 13.4 percent for 
Fannie Mae and 13. 1 percent for Freddie Mac - smaller percentages than those of each of the 
other secondary market participants. While analysis based on raw HMDA data has various 
limitations, it still provides a broad overview of relative market shares." 

An examination of lending activity broken down by credit risk also suggests that Fannie 
Mae and Freddie Mac do not provide a disproportionate share of credit to targeted borrower 
groups. Institutions that take on credit risk (i.e., the risk that a borrower will fail to make 
agreed-on payments) play a critical role in the mortgage lending process. When a mortgage 
bank originates an FHA-guaranteed loan, the FHA holds the credit risk; when a depository 
institution originates a conventional loan and holds the loan in portfolio, it holds the credit 
risk; when Fannie Mae purchases a conventional loan, it holds the credit risk. 

A study of 1994 lending activity by Canner and Passmore (1995- A) identifies the 
entities bearing the credit risk in the overall mortgage market and in various subsections of the 
market.^" The analysis in that study makes adjustments to incorporate private mortgage 
insurance companies. In keeping with their charters, Fannie Mae and Freddie Mac typically 
require such insurance on any mortgage with a loan-to-value ratio above 80 percent. 
Depository institutions also hold and purchase loans with private mortgage insurance. Thus, 
for loans with private mortgage insurance, the insurance company holds some of the risk, and 
other entities hold the rest. 

Canner and Passmore (1995- A) split the mortgage market by loan size and borrower 
characteristic to estimate who holds the credit risk on mortgages made to targeted borrower 
groups. Table III. 7 summarizes some of the results involving the relative share of targeted 
borrower loans in the mortgage-credit-risk portfolios of mortgage-market participants. The 
mortgage-credit-risk portfolio consists of all the mortgages for which a risk holder bears the 
credit risk. The summary in Table III. 7 of loans falling within the FHA single-family loan 



'* As noted previously, Ginnie Mae does not actually securitize or purcha.se mortgages but guarantees the 
timely payment of principal and interest on mortgage-backed securities made up of FHA and VA 
mortgages. In what follows in this study, the term securitize or purchase in relation to Ginnie Mae will 
refer to this guarantee function. 

" Raw HMDA data as presented in Table III. 6 include home purchase, refinancing, home improvement, 
and mobile home loans. The prevalence of these types of loans in a secondary market participant's 
purchases may affect targeted borrower purchase percentages. HMDA data also include only the initial 
sale of a mortgage in the secondary market. 

* Specifically, Canner and Passmore (1995-A) analyze owner-occupied home purchase mortgages 
originated between January and October of 1994. Canner and Passmore perform various adjustments to 
address limitations associated with analyzing raw HMDA data. 



61 

limit — mortgages less than $77,197 (ranging up to a maximum of $152,362 in designated 
high-cost areas) -- includes the vast majority of targeted borrower loans. Table III. 7 indicates 
that 39.8 percent of all FHA-eligible loans originated in 1994 were made to lower-income 
borrowers, 15.9 percent were made to African-American or Hispanic borrowers, 14.5 percent 
to lower-income census tract borrowers, and 9.8 percent to minority census tract borrowers. 
The table also shows that 40.9 percent of the FHA-eligible loans (without private mortgage 
insurance) held in depository institutions' portfolios were to lower-income borrowers, while 
35.5 percent of the FHA-eligible loans (without private mortgage insurance) purchased by 
Fannie Mae and Freddie Mac were to lower-income borrowers. 



62 



Table ITT.7: Relative Share of Targeted Borrower Ix)ans in the Credit Risk Portfolios of 
Mortg a ge Market Participants, 1994 (FHA-eligible loan size category) 
(in percentage points) 





Lower Income 
Borrowers' 


African Amer. 
or Hispanic 
Borrowers 


Lower Income 
Census Tracts' 


Predominately 
Minority Census 

Tracts' 


All 


39.8 


15.9 


14.5 


9.8 


FHA Insured 


45.1 


25.7 


17.8 


13.3 


VA Insured 


40.3 


19.6 


14.0 


9.1 


Depository Inst. Portfolio 
Holdings^ 


40.9 


11.6 


15.5 


8.8 


Loan Purchaser^ 










Fannie Mae or Freddie Mac 


35.5 


9.7 


10.5 


7.7 


Depository Inst, not Affiliated 
with Mortgage Originator 


34.9 


8.8 


10.7 


7.1 


Other Purchaser' 


40.7 


11.1 


13.6 


8.4 


Affiliate from an Ind. Mortgage 
Company 


42.5 


13.5 


13.2 


9.3 


Affiliate from a Depository Inst. 


44.0 


13.8 


16.9 


8.1 



Source: Canner and Passmore (1995-A, Table 3, p. 1000) calculated from 1994 HMDA data. 

' Canner and Passmore define lower-income borrowers as having less than 80 percent of the median MSA 

income, lower-income census tracts as having a median family income of less than 80 percent of the MSA 

median family income, and predominately minority census tracts as having a minority population that is 

larger than 50 percent of the tract's total population. 

^ The relative shares for depository institution portfolio holdings and loan purchaser categories are for 

loans without private mortgage insurance. Relative shares for loans with private mortgage insurance are 

lower for these borrower categories. 

' The other purchaser category in this table includes investment banks, life insurance companies, pension 

funds, and other private companies that securitize mortgages. 



According to these figures, Fannie Mae and Freddie Mac have a lower relative share of 
loans to targeted borrower groups than do most of the other mortgage market participants. 
The relative lower-income market share of Fannie Mae and Freddie Mac (35.5 percent) is also 
below the overall lower-income market share (39.8 percent) for FHA-eligible loans, a pattern 
repeated in the other targeted borrower groups shown in Table III. 6. Canner and Passmore 



63 

(1995-B, p. 1006) suggest that the difference between Fannie Mae and Freddie Mac and 
depository institutions in performance in targeted areas "may arise because Fannie Mae and 
Freddie Mac, unlike depositories, generally have no interactions with borrowers and are not 
located in the neighborhoods where the mortgages are originated; thus they lack the 
opportunity to look beyond traditional measures of risk." This conclusion is also suggested by 
the Federal Reserve Board (1993, p.4): "The additional information about the borrowers and 
neighborhoods gained by being directly involved with borrowers and located in a 
neighborhood may enable depository institutions to break the statistical links between 
neighborhood characteristics and loan performance."^' 

b. Share of Overall Market Serving Targeted Borrower Groups 

The statistics just described indicate that Fannie Mae and Freddie Mac make a 
relatively smaller portion of their mortgage purchases from targeted borrowers or locations 
than do most other secondary market participants. The data also show that the two GSEs incur 
a relatively smaller amount of credit risk from lending to targeted borrower groups than do 
other mortgage market participants. Still these data only show that the two GSEs are not 
market leaders in the share of their business devoted to such targeted borrower groups. The 
data do not indicate how the GSEs' volume of loans to targeted borrower groups compares to 
that of other mortgage market participants; it is quite possible to have a high percentage of 
business in certain communities but an overall low volume of loans. ^^ Also, considering only 
secondary market participants (as in Table III. 6) ignores depository institutions that originate 
and hold mortgages in their own portfolio, which make up a significant portion of the market. 

To analyze this issue, Canner and Passmore (1995-A) compare the overall market 
allocation of the credit risk associated with lending to targeted borrower groups. Since our 
analysis does not focus on the precise allocation of credit risk to private mortgage insurers, we 
allocate the portion of the credit risk held by the insurer to the partner entity. This calculation 
gives a sense of various institutions' direct participation in lending to targeted borrower 
groups. Table III. 8 summarizes the Canner and Passmore results for FHA-eligible loans. 



^' After doing a similar analysis, HUD (1995-C) concluded that non-GSE portfolio lenders (i.e., banks and 
thrifts) serve more credit-constrained borrowers than do the GSEs. "The apparent borrower differences 
... may be due to the portfolio lenders' greater knowledge of local markets, to the portfolio lenders' 
flexibility in underwriting borrowers that they know to be good risks based on long-term customer 
relationships, and to the funding by non-GSE portfolio lenders of certain types of properties ~ such as 
mobile homes - which the GSE lenders will only fund under more restrictive conditions" (p. 4-3). This 
conclusion is also consistent with that of the Federal Reserve. 

^ For example in Table III. 5 the Farmers Home Administration has a high share of targeted borrowers in 
its loan purchases but those purchases make up only a small percentage of total purchases from these 
groups. 



64 



Table TIT. 8: Summary of the Overall Allocation of the Credit Risk Associated with Tending tn 
Tar geted Borrower Groups, 1994 (FHA-eligible loan size category^ 
(Percentage of the total number of loans in borrower categories) 





Lower Income 
Borrowers 


Black or 

Hispanic 

Borrowers 


Lower Income 
Census Tracts 


Predominately 

Minority 
Census Tracts 


FHA/VA Insured 


34.3 


47.8 


36.3 


38.9 


Depository Institutions' 


33.0 


25.0 


33.9 


28.8 


Fannie Mae and Freddie Mac' 


21.1 


17.0 


18.5 


20.4 


Other Secondary Market Purciiasers' 


8.1 


6.0 


7.4 


7.0 


Independent Mortgage Companies* 


3.6 


4.1 


3.8 


4.9 



Source: Canner and Passmore (1995- A, Table 4, p. 1004) 

Note: Columns may not add exactly to 100 percent because of rounding. 

' The market share for depository institutions is obtained by adding depository institutions' holdings (with 

and without private mortgage insurance, or PMl), purchases by a bank or savings association not affiliated 

with a mortgage originator (with and without PMI), and purchases by an affiliate from a depository 

institution or its subsidiary (with and without PMI). 

^ The market share for Fannie Mae and Freddie Mac is obtained by adding their purchases with and 

without PMI. 

' The market share for other secondary market purchasers is obtained by adding their purchases with and 

without PMI. This category includes investment banks, life insurance companies, pension funds and other 

private companies that securitize mortgages. 

■* The market share for independent mortgage companies is obtained by adding independent mortgage 

company holdings (with and without PMI), and purchases by an affiliate from an independent mortgage 

company (with and without PMI). 



In the FHA-eligible loan size category, FHA and VA hold the largest share of credit 
risk and depository institutions have the second largest share. In fact, FHA, and VA, and 
depository institutions bear well over 60 percent of the credit risk for FHA-eligible loans to all 
categories of targeted borrowers. Combined, Fannie Mae and Freddie Mac hold about 20 
percent of the credit risk for each targeted group. 

Depository institutions' portfolio holdings appear to contribute significantly to 
affordable housing lending, a conclusion further supported by a 1995 Consumer Bankers 
Association survey, which was described in Elmendorf and Brough (1995). The survey 
reports that although 50 percent of the responding institutions sold some of their affordable 



65 

housing loans into the secondary market, the institutions retained an average of 77 percent in 
their own portfolios." 

In sum, a number of measures indicate that Fannie Mae and Freddie Mac finance a 
smaller portion of loans to targeted borrowers than do FHA and VA, and insured depository 
institutions. This result is consistent with HUD (1995-C) data comparing the GSEs' affordable 
housing activities with FHA and other lenders. Table III. 9 shows these comparisons across 
income, race/ethnicity, and location for home purchase mortgages guaranteed by FHA or 
acquired by the GSEs in 1993. Because Congress designed FHA specifically to support the 
affordable housing segment of the market, it is not surprising to find that FHA serves 
relatively more low-income and other targeted borrowers than do the GSEs, which provide 
general liquidity to a broad spectrum of the market. 



^ Affordable housing loans for the purpose of the Consumer Bankers Association survey were defined as 
loans made through a program designed to increase purchase-money home mortgage lending to minority or 
low- to moderate-income applicants. The Consumer Bankers Association has conducted its survey, known 
as the Affordable Mortgage Program Survey, annually since 1992. 



66 



Table TII.9: Distrihutinn of Borrower and Census Tract Characteristics of FHA and GSE 
Home Purchase Mortg a ges in Metropolitan Areas. 1993 



Borrower and Census Tract Characteristics 


FHA 


GSE 


All 


Eligible-Only 


Income of Borrower 








80 % of Median or Below 


42.0 


18.3 


28.0 


81-100 % of Median 


23.0 


15.3 


20.9 


101-120 % of Median 


16.0 


15.7 


17.6 


121-150 % ofMetlian 


11.8 


19.3 


16.6 


+ 150 % of Median 


7.2 


31.4 


16.8 


Under Median 


65.0 


33.6 


48.9 


Over Median 


35.2 


66.4 


51.0 


First-time Homebuyer 


66.8 


30.7 


35.0 


Repeat Homebuyer 


33.2 


69.3 


65.0 


Race/Ethnicity of Borrower 








White 


78.1 


87.6 


86.9 


Black 


10.0 


2.7 


3.0 


Hispanic 


9.5 


4.2 


4.8 


Asian 


2.0 


4.3 


4.1 


Other 


0.4 


1.2 


1.2 


♦Income of Tract 








80 % of Median or Below 


16.1 


6.7 


8.8 


81-100 % of Median 


29.7 


18.3 


22.9 


101-120 % of Median 


29.9 


27.7 


30.6 


121-150 % of Median 


19.0 


29.0 


26.0 


+ 150 % of Metlian 


5.3 


18.3 


11.7 


♦Minority Composition of Tract 








10 % Minority or Less 


43.1 


57.3 


56.4 


11-30 % Minority 


34.8 


30.5 


30.1 


31-50 % Minority 


10.3 


6.5 


6.8 


+ 50 % Minority 


11.8 


5.7 


6.7 


Underserved Areas 


27.1 


12.7 


15.5 


Servetl Areas 


72.9 


87.3 


84.5 



Source: An Analysis of FHA 's Single-Family Insurance Program. (HUD, 1995-C, pp. 4-26). 



67 
D. Summary 

Over the last 30 years, the secondary mortgage market has developed rapidly, assisted 
by the federal government's support for Fannie Mae, Freddie Mac, and Ginnie Mae. Both 
Fannie Mae and Freddie Mac have been instrumental in developing new products that 
increased the availability of mortgage credit under various economic circumstances. 

Since the late 1980s the non-conforming mortgage market and other financial markets 
have successfully replicated the GSEs' function of linking capital markets to individual credit 
markets. These non-GSE secondary markets demonstrate private firms' ability to keep 
secondary markets liquid without government support. In addition, the sheer size of the 
mortgage market, together with the participation of large national and regional firms, provides 
considerable stability to the market. These developments suggest that the secondary market for 
conforming, conventional mortgages could operate efficiently and effectively were Congress to 
end government sponsorship of Fannie Mae and Freddie Mac. Nevertheless, as explained in 
the next chapter, a number of important uncertainties remain. 

That chapter also considers the uncertainties concerning the GSEs' contributions to 
affordable housing. While both Fannie Mae and Freddie Mac participate actively in expanding 
opportunities for affordable housing, other market participants appear to be the leaders in 
providing credit to targeted borrowers. Despite the best efforts of Fannie Mae and Freddie 
Mac, the fact that those companies operate in the secondary market for mortgage loans issued 
under relatively conservative underwriting guidelines may put them at a disadvantage in 
actively promoting affordable housing loans. They may also lack the advantages that have 
helped depository institutions succeed in this area: direct participation in primary markets, 
local knowledge, and greater outreach in low-income communities because of CRA. 

Without government sponsorship, the GSEs would have fewer incentives to continue 
serving various affordable housing markets. In addition, revitalized CRA regulations for 
FDIC-insured depository institutions that have stimulated affordable housing finance may, over 
the long run, stimulate more affordable housing activity by the GSEs and other market 
participants. On the other hand, rescinding the affordable housing goals (or similar 
obligations) attendant on GSE status would reduce the incentives for Fannie Mae and Freddie 
Mac to purchase at least some affordable housing loans, particularly those with higher LTV 
ratios or higher information and transaction costs. It could also limit certain other forms of 
assistance currently provided. Even if the GSEs lost their government sponsorship and 
reduced their affordable housing activity, the characteristics of their affordable housing loans 
suggest that the private sector could readily finance most of these loans. Chapter IV considers 
this from a broader perspective. 



69 
CHAPTER rV 

POTENTIAL EFFECTS OF ENDING GOVERNMENT SPONSORSHIP 
AND OF MAINTAINING THE STATUS QUO 



Without government sponsorship, Fannie Mae and Freddie Mac would probably 
continue to compete and prosper in the secondary mortgage market, and that market would 
probably retain the liquidity and regional stability it now displays. Yet the broader potential 
effects of ending such sponsorship remain uncertain. Nor can one know exactly how the 
mortgage market would evolve if such sponsorship continues. What is certain is that U.S. 
financial markets, and the housing finance market in particular, are undergoing dramatic 
changes, many of them driven by advances in technology. While such changes can create 
troubling uncertainties, they should ultimately benefit consumers and the economy. Mindful of 
such changes, we attempt to evaluate some of the broad economic and social effects of ending 
or retaining government sponsorship of Fannie Mae and Freddie Mac. 

A. Risks of Ending Government Sponsorship 

We will consider here how ending government sponsorship could introduce uncertainty 
into the mortgage market, increase mortgage costs, and reduce affordable housing efforts. 
Fannie Mae and Freddie Mac have played a central role in developing the efficient, liquid 
mortgage market we enjoy today. They have developed it so successfully that some have 
asked whether the market could operate effectively without government sponsorship. The two 
GSEs, in meetings with Treasury officials, have stated that they could restructure themselves 
to operate without government sponsorship, but that losing such sponsorship would raise 
mortgage costs. 

1. Effect on the Liquidity and Stability of the Mortgage Market 

Despite the strength of the secondary mortgage market, precipitous change in the 
GSEs' government sponsorship could pose potential risks for that market. Government 
sponsorship enables the GSEs' debt and mortgage-backed securities to receive better than AAA 
rates. A secondary market without GSE support would need to find other sources of credit 
enhancement to raise similar sums. The private sector has successfully provided such credit 
enhancements in other segments of the home mortgage market and in other markets but, given 
the large volume of securities issued by Fannie Mae and Freddie Mac, ending government 
sponsorship may at least cause some initial uncertainty. 

In response to changing market conditions and the search for more efficient structures, 
private asset-backed securities markets have greatly increased their capacity to provide credit 
enhancement. They have developed structures ranging from pool insurance to the currently 



70 

more common division of debt into senior and subordinated instruments. Some private 
companies specialize in providing credit enhancement to municipal bond issuers. In the long 
run, one would expect financial markets to develop the capacity to provide the level of credit 
enhancement necessary to accommodate the GSEs' volume of securities. Interest rates on such 
securities might still rise without government sponsorship, but the market could remain liquid 
and stable. 

In the short run, the private market may have greater difficulty in providing the level of 
credit enhancement necessary to absorb the GSEs' current volume of securities without an 
increase in interest rates. This would certainly be the case if government sponsorship of 
Fannie Mae and Freddie Mac ended abruptly. Given the GSEs' current importance to the 
mortgage market, an abrupt end to government sponsorship would not be a prudent policy 
choice. 

Furthermore, any changes in government sponsorship need not be made in isolation. 
Policymakers could consider changing other statutes and regulations to improve the liquidity 
and stability of a fully private secondary mortgage market. Congress already took one such 
step with the Secondary Mortgage Market Enhancement Act of 1984. The Act preempted 
certain state investment laws, thereby allowing depository institutions and institutional 
investors such as pension funds to purchase privately issued mortgage-backed securities as if 
they were issued by a federal agency or a GSE. Federal banking regulators might consider re- 
examining the risk-based capital treatment of privately issued mortgage-backed securities, 
which have a 50 percent risk-weight versus the 20 percent risk-weight assigned to GSE-issued 
mortgage-backed securities.' 

2. Effect on Mortgage Interest Rates 

Another concern is a potential increase in home mortgage rates for conforming, 
conventional fixed-rate loans. It is difficult to estimate with certainty how modifying or 
ending government sponsorship would affect mortgage interest rates. It appears that if federal 
sponsorship were ended, mortgage rates in this segment of the market would rise, though the 
effect is both hard to estimate and likely to be small relative to the normal fluctuations in 
mortgage rates attributable to macroeconomic and credit market factors. 

There is no theoretical or legal reason why the GSEs must pass through all, or even 
part, of their subsidies to consumers. Hermalin and Jaffee (1996) explain how duopolists can 
increase their profits through tacit cooperation.^ They point out that reducing subsidies may 



' The OTS uses a 20 percent risk-weight for both GSE and privately issued mortgage-backed securities. 

^ As Hermalin and Jaffee point out, tacit cooperation requires no actual collusion. Rather, it is possible for 
duopolists, acting Independently and solely in their own individual interests, to act as if they were 
colluding. 



71 

not increase mortgage rates if the GSEs priced just low enough such that other competitors stay 
out of the market. In general, the GSEs' pricing strategy, and the threat of competitor entry 
into the conforming loan secondary market, will determine whether and how much of the 
subsidy is passed through in lower mortgage rates and, in turn, how any reduction in subsidies 
would affect conforming mortgage rates. 

Empirical evidence of the GSEs' effect on conforming loan rates is also inconclusive. 
The GSEs point to comparisons of mortgage offer rates in weekly newspapers as evidence of a 
pass-through. A review of such rates in the weekly Washington Post real estate section shows 
that lenders' quote on conforming rates generally running 25 to 50 basis points below their 
quotes on jumbo rates, although the difference recently diminished. 

One concern about this comparison is that offer rates can and do differ from the rates at 
which loans are actually closed. Table IV. 1 presents national averages on closed fixed-rate 
mortgages for both conforming and non-conforming loans. ^ 



Table IV. 1 : National Averages on Fixed-Rate Mortgages 



Y«>r 


Conforming 

Effective Rate 

(percent) 


Jumbo 

Effective Rate 

(percent) 


Jumbo 

Differential 

(basis points) 


1983 


12.86 


12.4 


-46 


1990 


10.38 


10.56 


18 


1991 


9.66 


9.75 


9 


1992 


8.49 


8.6 


11 


1993 


7.48 


7.46 


-2 


1994 


8.19 


7.78 


-41 


1995 


8.18 


8.16 


-2 



Sources: Mortgage Interest Rate Survey (MIRS) conducted by the Federal Housing Finance Board 
(Federal Home Loan Bank Board prior to 1989). 1983 estimates, from GAO (1984), include both fixed- 
and adjustable-rate mortgages. 



' The effective rate adjusts the contract rate for initial fees. MIRS data amortize the initial fees over a ten 
year time period to obtain the effective rate. 



72 

The GAO (1984) first reported that the 1983 national average rate of jumbo loans was less 
than that of conforming loans. During the 1990s, the differential on national averages between 
conforming and jumbo loans has varied in size and sign. For the three-year period 1993-95, 
however, jumbo loans bore lower average effective rates than conforming loans. 

Relying on national averages of closed rates to analyze the GSEs' effect on the interest 
rates of mortgages below the conforming loan limit also has shortcomings. Simple averages of 
mortgage rates across time cannot fully capture factors that could cause mortgage rates to vary 
according to loan characteristics such as loan size or credit quality. In addition, annual 
national averages do not account for such factors as any regional differences in mortgage rates 
or the timing of mortgage closures. 

Several research papers, including one prepared for the interagency group (Cotterman 
and Pearce, 1996)," use econometric models to control for various factors that may affect the 
mortgage-rate differential between conforming and jumbo loans, such as geographic location, 
time of loan closing, loan size, and default risk. By controlling for such factors, an 
econometric model attempts to isolate the GSEs' effect on conforming mortgage rates. The 
Cotterman and Pearce paper, which builds on earlier work, estimates that closed conforming 
fixed-rate mortgages have had interest rates roughly 25 basis points (in 1993) to 60 basis points 
(in 1989) below the rates on jumbo mortgages. Of this range, Cotterman and Pearce view the 
core range of the differential as 25 to 40 basis points. A sample of their estimates is presented 
in Table IV. 2. The Cotterman and Pearce estimates are similar to those found by other 
researchers. For example, ICF (1990) found that conforming loans had interest rates 23 basis 
points less than jumbo loans. Hendershott and Shilling (1989) found a 30 basis point 
differential.' Fannie Mae (1996-C, p. 218), in written comments on a preliminary draft of 
Cotterman and Pearce, identified a 20 to 35 basis point differential as reasonable and 
consistent with earlier findings using similar data.^ Therefore, in Chapter II we assumed 20 to 
40 basis points as a reasonable range for the possible pass-through of the GSEs' governmental 
benefits. 

Table IV. 2 also shows that the differential declined in recent years. This decline 
corresponds with the rapid growth of securitization in the jumbo market. These researchers 
also found that stacking - i.e., the concentration of a large number of mortgages ~ at the 



' See also Hendershott and Shilling (1989) and ICF (1990). Shilling (1996) and Cook (1996) comment on 
Cotterman and Pearce. Hermalin and Jaffee (1996) also offer insights into this issue, as do comments on 
their paper from White (1996) and Kaufman (1996). 

' Both Hendershott and Shilling (1989), and ICF (1990), reported smaller differentials for jumbo loans that 
were close to the conforming loan limit. For the time period covered by these studies, this effect was 
particularly important since the conforming loan limit was increasing regularly. 

* Cotterman and Pearce (1996), in a preliminary draft of their paper, concluded that the conforming loan 
differential had a core range of 20 to 35 basis points. 



73 



conforming loan limit declined during the same period. Although the Cotterman and Pearce 
results are the best econometric evidence currently available, they involve a relatively simple 
model/'* and include no data after 1993. Given the rapid fall in the conforming loan 
differential that they estimate between 1989 and 1993, an update of their analysis would be 
particularly useful. 



Table IV.2: Estimated Differences in Rates Between Ju mbo Loans and Conforming I^ans By 
lender, 1989-1993 
(in percentage points) 





California 


Total for 1 1 States 


Year 


S&Ls 


Mortgage 
Companies 


S&Ls and 
Mortgage 
Companies 


S&Ls 


Mortgage 
Companies 


S&Ls and 
Mortgage 
Companies 


1989 


-0.45 


-0.51 


-0.50 


-0.31 


-0.59 


-0.59 


1990 


-0.34 


-0.35 


-0.36 


-0.35 


-0.36 


-0.38 


1991 


-0.48 


-0.46 


-0.47 


-0.33 


-0.49 


-0.43 


1992 


-0.17 


-0.38 


-0.32 


-0.21 


-0.30 


-0.30 


1993 


-0.19 


-0.28 


-0.25 


-0.28 


-0.23 


-0.24 



Source: Cotterman and Pearce (1996, p. 125, Table 6) 



In the face of conflicting data on offer rates and closed rates, theoretical uncertainty 
over how much the GSEs pass through their benefits by lowering mortgage rates, and the 
problems associated with estimating the effects of government sponsorship, we cannot make 
definitive statements about the degree to which reducing or eliminating government 
sponsorship would affect conforming mortgage rates. Further study is needed to estimate 
more precisely the GSEs' effects on mortgage rates below the conforming loan limit. 



' No doubt due to data limitations, the Cotterman and Pearce model includes information on relatively few 
of the variables that should affect loan rates. A more complete analysis would also model the joint 
determination of loan approval or disapproval, amount, and interest rate. 

' The relationship between loan rate and loan size appears particularly complex, both theoretically and 
empirically. Consequently, a simple measure or estimate of the difference between contormmg and jumbo 
mortgage rates masks a more complicated relationship between mortgage rates and mortgage size. 



74 

The information currently available indicates that the potential increase in mortgage 
rates would be small relative to the normal fluctuations in mortgage rates attributable to 
changes in macroeconomic and credit market conditions. Figure IV. 1 shows quarter-to-quarter 
changes in average mortgage rates between 1991 and 1995. As the figure indicates, mortgage 
rates regularly change by considerably more than any change that could reasonably be expected 
from ending government sponsorship. To provide a benchmark for assessing the effect of a 
rise in mortgage interest rates, consider the following example. The median-priced home in 
the U.S. in 1995 was $1 12,900 and the average mortgage rate on a 30-year, fixed-rate 
mortgage was 7.95 percent.' Assuming the homebuyer made a 20 percent downpayment, a 20 
basis-point increase in mortgage rates would increase the monthly payment by $12 per month. 
Assuming the homebuyer is in the 28 percent marginal tax bracket and pays state taxes at a 
marginal rate of 5 percent (net of the federal deduction), the after-tax cost of a 20 basis point 
increase would be $8 per month. 



Fi gure IV. 1: Quarterly Changes in Average Mortg a ge Rates 



BASIS 
KXKTS 



ao 

70 

«o 
so 

40 

X 
30 

10 



■10 

•30 

oo 

■40 

■K 
■70 
40 



m 



i 



t 




I 



s 



FcW*! 



Fcb-n 



Ttb-n 



Ttb-U 



Feb-W 



Source: HUD (1996-D) 



In summary, it is not clear to what extent interest rates for fixed-rate conforming, 
conventional mortgages would increase if Congress ended the government's sponsorship of 
Fannie Mae and Freddie Mac, although such rates probably would rise. To the extent that 



See HUD (1996-D). 



75 

observed differences in rates between conforming and jumbo mortgages reflect economic 
factors such as credit risk, or technical efficiencies achieved by the GSEs, ending such 
sponsorship may have almost no effect on mortgage rates. But to the extent that lower 
conforming mortgage rates reflect a current pass-through of at least some of the GSEs" 
governmental subsidies, as we assumed in Chapter II, then ending such sponsorship could lead 
to a slight increase in mortgage rates. If ending the GSEs' government sponsorship increased 
secondary mortgage market competition, however, that could in the long-run mitigate or even 
offset any such rate increase. 

3. Effect on Affordable Housing Efforts 

Congress has created a role for the GSEs in affordable housing, to which they have 
responded by substantially increasing their purchases of loans to lower-income homebuyers 
and on properties in under-served communities. Of course, the GSEs' affordable housing 
goals are only one of a set of government initiatives to promote affordable housing. The 
Community Reinvestment Act (CRA), for example, increases the incentives for primary 
lenders to make affordable housing loans. 

While predicting future contributions by the GSEs and others to affordable housing is 
difficult, it may help to consider the challenges that the GSEs face relative to other participants 
in the affordable housing market. First, the GSEs do not make loans directly to homebuyers. 
Although they can offer products designed for affordable housing, they must rely on primary 
lenders to bring them such loans. Also, the GSEs have a number of active competitors in the 
affordable housing market, including the FHA, which focuses directly and primarily on 
affordable housing, and portfolio lenders, which have the advantage of better local knowledge. 

The challenges faced by the GSEs are heightened by the fact that today's critical 
housing priorities center not on the general operation of the nation's credit markets but on the 
needs of certain borrowers that continue to find homeownership beyond their grasp. Last 
year, the Administration established the goal of increasing the U.S. homeownership rate to a 
historic high - 67 percent of all households. HUD released a blueprint for achieving this 
goal, the National Homeownership Strategy: Partners in the American Dream. '" The strategy 
includes 100 action items for increasing homeownership rates nationwide. It also identifies a 
lack of funds for downpayments and insufficient income - not credit availability - as the two 
main financial barriers to homeownership among the targeted borrower groups. As the 
National Strategy report points out, "obtaining sufficient funds to purchase a home for many 
low- and moderate-income households will require government and nonprofit financial 
support" (HUD, 1995, p. 4-11). For the country to meet today's critical housing needs, 
public policy attention should focus on the action items outlined in the HUD strategy. Again, 



'" HUD (1995). At the end of 1992, the national homeownership rate was 64. 1 percent. By the end of 
1995, the rate had increased to 65.1 percent. 



76 

the GSEs face challenges in helping to solve this problem. For the GSEs to buy a mortgage, 
they must first obtain mortgage originations that meet their underwriting standards 
(recognizing that the GSEs have recently modified some of their underwriting standards to 
boost their purchase of affordable housing loans). Also, for most affordable housing loans, a 
private mortgage insurance company must take the first-loss risk before the GSEs may 
purchase the loans." 

Despite these challenges, Fannie Mae and Freddie Mac have contributed to promoting 
affordable housing finance. It is unclear whether the two companies need government 
sponsorship to continue their current efforts; knowing that would require more information on 
whether the GSEs' affordable housing efforts generate returns significantly below those of 
comparable lines of business. As described in the previous chapter, the majority of affordable 
housing loans purchased by the GSEs meet standard underwriting criteria. Freddie Mac states 
that "the corporation purchases most single-family and multifamily mortgages in support of 
affordable housing through its standard mortgage purchase programs and under the same credit 
standards as its other mortgage purchases" (Freddie Mac, 1996-B, p. 4), but this statement 
does not preclude some extraordinary efforts aimed at small groups of homebuyers. 

Therefore, ending government sponsorship would leave at risk some smaller subset of 
the GSEs' purchases of affordable housing loans. This subset, typically referred to as 
community lending loans, consists of loans that target various groups of borrowers through 
flexible underwriting (lower debt or income ratios, and reduced down payments). HUD 
(1996-A) has reported that the GSEs purchased some 97,000 such loans, worth a total of $7.5 
billion, in 1995. Community lending comprised 7 percent of Fannie Mae's total owner- 
occupied single- family purchases and 1 percent of Freddie Mac's. '^ 

Another area of concern is how ending the GSEs' government sponsorship would affect 
homeownership opportunities. A study by Wachter et. al. (1996) predicts that it would reduce 
the overall homeownership rate, especially among first-time homebuyers and targeted 
borrower groups. These results must, however, be kept in perspective. In particular, the 
Wachter analysis could overstate the effects of ending government sponsorship for several 
reasons, some of which are presented below. '^ The Wachter analysis did not consider the 
ability of households to use adjustable-rate mortgages and assumed that ending government 
sponsorship would cause: 



" One promising development that may lower the cost of buying a home for all potential homebuyers is 
new technology that reduces the cost of originating and underwriting mortgages. Fannie Mae and Freddie 
Mac are actively involved in developing such technology, as are fully private firms. 

'^ HUD (1996-A) reports that in 1995 the community lending purchases of Fannie Mae were 86,374 
($6,550 billion) and Freddie Mac's were 10,869 ($935 million). 

" Yezer (1996) also discusses issues related to the Wachter et. al. (1996) analysis. 



77 

• Downpayment requirements to increase. This may not be a likely occurrence, 
however, since the fully private sector offers low downpayment mortgages enhanced 
through private mortgage insurance companies. 

• A 50 basis point increase in mortgage rates. Such an increase exceeds those suggested 
by other research cited earlier in the chapter. Even if rates rose that much, it is unclear 
it could have such a broad effect on homeownership. 

Although Wachter et. al. (1996) raise many important questions about ending government 
sponsorship and about overall housing policy, more research is necessary to determine the 
effect on homeownership rates. 

The federal government has in place a specialized system for insuring and securitizing 
affordable housing loans -- FHA and Ginnie Mae. It also recently established the Community 
Development Financial Institutions (CDFI) fund to leverage public and private capital for 
community development activities including affordable housing projects. These government 
entities may be best equipped to target subsidies to specific borrower groups. Their current 
and future activities need to be considered when evaluating the effect that ending government 
sponsorship of Fannie Mae and Freddie Mac might have on the government's ability to 
achieve the goals laid out in the National Homeownership Strategy. 

B. Risks of maintaining the Status Quo 

Just as government sponsorship has real value and involves real costs, maintaining such 
sponsorship would involve risks that may benefit from further analysis. As described here, 
these risks include the effect of government sponsorship on Treasury borrowing costs, on other 
credit markets, on competition in the mortgage market and increased reliance on GSEs, and on 
the potential risk to the taxpayers. They also include the tension between the GSEs' public 
purpose and their responsibility to their shareholders. 

1. Effect on Treasury Borrowing Costs 

In addition to the implicit subsidies covered earlier in this report, government 
sponsorship may involve an explicit cost through increased Treasury borrowing costs. The 
large number of variables that affect financial markets make it difficult to ascertain to what 
extent GSE securities affect Treasury borrowing costs. However, the ways in which such 
securities could affect those costs are clear. First, if the GSEs increase the total demand for 
credit above what it would have been without government sponsorship, then the law of demand 
suggests that the GSEs must be raising all interest rates, including those for Treasury 
securities. While the GSEs issue a large volume of securities, any net additional demand for 
credit created by their government sponsorship is probably fairly small. 



78 

Second, since GSE securities serve as substitutes for Treasury securities for many 
purposes, and since they benefit from investors' perception that the federal government 
implicitly stands behind them, those securities compete directly with Treasury securities in the 
government securities market. To some extent, therefore, the considerable and growing 
supply of GSE securities (relative to the supply of Treasury securities) tends to lower prices in 
the government securities market and thereby increase the Treasury's borrowing costs. 

Unfortunately, it is extremely difficult to estimate the amount of the increase. 
Financial markets are both dynamic and complex; many factors affect their demand, supply, 
and segmentation. When the Treasury previously attempted (Treasury 1990, 1991) to estimate 
the effect of GSE borrowing on Treasury costs, it could not quantify those effects. These 
estimation difficulties remain; nonetheless, further analysis seems appropriate. Together, 
Fannie Mae and Freddie Mac had over $1.4 trillion in debt and mortgage-backed securities 
outstanding at the end of 1995. Since the public holds $3.7 trillion of U.S. government debt, 
each basis point of increase in such costs would raise annual budgetary outlays by $370 
million. 

2. Effect on Other Credit Markets 

While the benefits of GSE status provide an important subsidy that promotes 
homeownership, such a subsidy has economic costs. To the extent that the GSEs pass through 
the benefits of government sponsorship, they reduce the price of, and increase the demand for, 
mortgage credit relative to other types of credit. The economic effect of the subsidy to 
mortgage credit — absent increases in the savings pool or attracting capital from abroad ~ is to 
raise the price or reduce the amount of credit for other uses, such as small businesses, 
exporters, rural communities, and other business and consumer borrowers. Measuring such 
effects, however, is even more difficult than measuring the potential effects on Treasury 
borrowing costs. 

3. Potential for Increased Reliance on the GSEs 

Maintaining the current GSE status of Fannie Mae and Freddie Mac could, over time, 
find the housing finance market increasingly reliant on the GSEs as sources of credit for 
conforming, conventional mortgages. This increased reliance, coupled with the advantages the 
GSEs receive from government sponsorship, could undermine the viability of portfolio lenders 
operating in local markets, such as community banks and thrift institutions. If that were to 
occur, borrowers who do not easily meet the GSEs' underwriting standards may lose 
competitive local mortgage sources that may serve their needs better than national lenders. 

Fannie Mae and Freddie Mac face potential competition from private- sector conduits 
now active in the secondary mortgage markets not dominated by Fannie Mae and Freddie 
Mac. One reason these firms do not now compete with the GSEs is that the benefits of 
government sponsorship deter entry into the market for fixed-rate conforming, conventional 



79 

mortgages. Ending government sponsorship would encourage more private sector participation 
in the market for such mortgages. Increased competition would probably not eliminate the 
benefits Fannie Mae and Freddie Mac have already brought to this market, such as 
standardization of loan terms. On the other hand, continuing government sponsorship prevents 
Fannie Mae and Freddie Mac from competing in other lines of business; free to bring their 
considerable skills to bear in other markets, they would likely benefit consumers in these other 
markets. 

The potential for competition in GSE-dominated markets is evident in the evolution of 
REMIC'" securities. The private sector rapidly began issuing REMIC securities soon after the 
Tax Reform Act of 1986 authorized them. In 1987, fully private issuers accounted for almost 
all issuance of REMICs. Once the two GSEs were permitted to fully participate in this 
market, they became the leading REMIC issuers. In 1993, the GSEs issued approximately 98 
percent of all REMICs.'^ If this concentration resulted from the GSEs' economies of scale, 
better technology, or some other form of superior economic efficiency, then privatization 
would probably not alter it. However, if it resulted from the benefits of government 
sponsorship, including a perceived implicit guarantee, privatization probably would increase 
competition. 

The limited competition faced by Fannie Mae and Freddie Mac — and the lack of direct 
secondary market competition — may distort resource allocation and decrease financial 
innovation. By removing the subsidies derived from their government sponsorship, 
privatization would enable Fannie Mae, Freddie Mac, private conduits, and depository 
institutions to compete more equitably in financing home mortgages. 

4. Effect on Potential Risk to the Taxpayer 

Although Fannie Mae and Freddie Mac have developed a range of mechanisms to 
hedge the risks of their portfolios and protect their financial integrity against movements in the 
financial markets, there is no guarantee they will always be safe and sound entities. We have 
no evidence of any current safety and soundness problems at Fannie Mae and Freddie Mac. 

The Shadow Financial Regulatory Committee recently highlighted questions regarding 
potential taxpayer risk: 

Whether or not a GSE actually becomes insolvent, taxpayers need to recognize 
that Treasury back-up implicitly supplies risk capital that enhances the value of 
private stakes in the firm. The availability of the implicit finance allows 



'* See footnote 8 in Chapter I for a definition of REMIC. 
" Mortgage Market Statistical Annual for 1995. 



80 

enterprise managers to escape the market discipline of making other 
arrangements to support their creditworthiness and promises to keep alive for 
GSE shareholders a claim on the enterprise's future profits in difficult times. 
This distorted arrangement for sharing risk makes private stakeholders willing to 
trade upside earning potential for downside risks at terms that disadvantage 
taxpayers.'* 

Because one cannot know in advance whether, or to what extent, the government would 
assist a financially troubled or failing GSE, managing any potential risk exposure is necessarily 
more difficult than managing the risks of an explicit guarantee. When making an explicit 
guarantee, the government can clearly define and limit its obligations, and other parties can 
adjust their conduct accordingly. The government can also take specific steps to minimize the 
risk of any claim against that guarantee -- for example, by regulating an entity whose 
obligations are being guaranteed. 

When there is no explicit guarantee, but merely a possibility that the government might 
provide assistance in the future, the nature and scope of any such assistance is unknown. 
Efforts to manage an undefined potential risk are problematic. 

In 1992, Congress sought to assure the safety and soundness of Fannie Mae and 
Freddie Mac, and thus reduce any potential taxpayer risk, by establishing the Office of Federal 
Housing Enterprise Oversight (OFHEO), an independent office within HUD. Congress 
charged OFHEO with assessing and maintaining the safety and soundness of the GSEs. 
OFHEO's regulatory duties include conducting examinations and establishing capital 
standards. It has the enforcement powers needed to respond quickly if problems arise. While 
still a new office, OFHEO's ongoing work in examining the two GSEs and developing risk- 
based capital requirements for them do help bolster the GSEs' safety and soundness, thereby 
making taxpayers better off Creation of OFHEO is a positive development that we expect to 
have a salutary effect on the two GSEs' safety and soundness. 

OFHEO's responsibilities are unusual because it regulates only two entities -- entities 
that comprise almost the entire secondary mortgage market for conforming, conventional 
mortgages. This concentration of regulatory scope has both advantages and disadvantages. 
OFHEO's structure provides a clear, focused safety and soundness mission, and strong 
accountability. Having only two institutions to regulate, OFHEO should be expert in the 
GSEs' operations and risks. On the other hand, that structure may also present challenges in 
the future. Since OFHEO oversees only Fannie Mae and Freddie Mac, it must continue to 
work diligently to retain an appropriate arm's-length independence from its regulated entities 
over time. In light of its relatively narrow mission, OFHEO will also need to maintain a 



'* Shadow Financial Regulatory Committee (1996, p. 2). 



81 

vision of the housing finance system and the operations of financial markets that does not 
become narrowed by its exclusive focus on two GSEs. 

If Congress were to end the GSEs' government sponsorship, we assume it would do so 
in a way that would remove any question of implicit taxpayer support and would thus make 
clear that investors bear the risks associated with the two companies' operations, just as they 
bear the risks of other fully private firms. Congress could then end safety and soundness 
regulation and subject Fannie Mae and Freddie Mac to full market discipline. 

5. The Tension Between Front and Public Purpose 

When creating a GSE, Congress defines the problem (i.e., the market imperfection) it 
seeks to overcome, provides benefits (subsidies), and imposes limitations on the GSE. But if 
Congress wishes to revise those decisions in response to changing public needs, it no longer 
has the same freedom of action: in addition to the usual constraints of the legislative process, 
it must contend with the private interests of the GSE and its shareholders. Congress must 
consider, and legislate, any such changes through a process in which the GSEs are significant 
participants. As a private company, the GSE will act to fulfill its fiduciary responsibilities by 
promoting and protecting the interests of its shareholders. 

Clearly Fannie Mae and Freddie Mac must serve their shareholders, but they must also 
comply with their federal charters. This ambiguity of responsibility, characteristic of GSEs, 
continually raises issues of accountability: To what extent is a particular GSE responding to its 
federal mandate and to what extent to the need to generate returns for its stockholders? What 
tradeoffs does it make between these objectives? 

C. Balancing the GSEs' Public Purpose and the Benefits of Government 
Sponsorship 

If Congress decided to maintain the GSE status of Fannie Mae and Freddie Mac, but 
sought to increase the public benefits they provide or reduce the government benefits they 
receive, it could pursue a wide range of options. 

Illustrative of the many options that have been suggested are the following: 

• Holding constant, or decreasing, the conforming loan limit to focus the GSEs more 
squarely on the market where affordability issues are most important; 

• Strengthening the affordable housing goals; 

• Requiring Fannie Mae and Freddie Mac to direct a portion of their earnings to 
affordable housing, perhaps along the lines of the Federal Home Loan Bank System's 
Affordable Housing Program (the System, another housing GSE, must annually make 



82 

grants for affordable housing that amount to the greater of $100 million or 10 percent 
of the System's earnings). 

• Requiring more directed assistance (both educational and financial) to lower-income 
borrowers, state and local governments, and non-profit organizations, as described in 
HUD's National Homeownership Strategy; 

• Charging user fees to recoup some of the benefits of government sponsorship; 

• Limiting the size of the GSEs' retained mortgage portfolio or requiring its divestiture 
(as Congress directed in 1954); and 

• Ending certain benefits of government sponsorship, such as the exemption from SEC 
registration. 

Analysis of any of these options would be a necessary part of the ongoing evaluation 
of the government's relationship with the GSEs in light of market developments. Also, 
policymakers would need to consider how such options would affect the GSEs and other 
government housing programs, especially FHA. Gradually decreasing the conforming loan 
limit (currently $207,000) could encourage the GSEs to increase their activity in the segment 
of the housing market most in need of assistance. Strengthening the affordable housing goals 
could also focus more of the GSEs' efforts on targeted borrowers. The goals recently 
published by HUD are actually below the relevant market shares for targeted borrower groups. 
The percentages could be increased or the definitions further tightened to try to better serve the 
public purpose. In addition, the goals could also place greater emphasis on increasing the 
GSEs' involvement in financing multifamily mortgages. 

Alternatively, one could require the GSEs to provide direct financial and technical 
assistance to institutions and government agencies involved in affordable housing. Both GSEs 
provide such assistance to various community organizations, but to better target public benefits 
the government could have input on the level and scope of these activities.'^ 

Imposing user fees on the GSEs' debt and mortgage-backed securities could recoup 
some of the GSEs' implicit government subsidy and level the playing field for other 



For example, the Fannie Mae Foundation provides charitable support for various housing initiatives and 
other projects. Fannie Mae officials expect the Foundation to spend between $50 and $70 million annually 
in the next five to seven years. By contrast, the Federal Home Loan Bank System must devote the greater 
of $100 million or 10 percent of net income to its statutorily defined Affordable Housing Program. If a 
similar 10 percent requirement had been applied to Fannie Mae and Freddie Mac in 1995, it would have 
raised $300 million (based on $3 billion in after-tax net income) to $450 million (based on approximately 
$4.5 billion in pre-tax net income). 



83 

competitors.'* Such fees could, however, create pay-as-you-go budget problems for any future 
legislation to end government sponsorship." 

Limiting the GSEs' retained mortgage portfolios (and thus requiring the GSEs to 
securitize more of the mortgages they purchase) would substantially reduce the benefits of 
government sponsorship retained by the GSEs' shareholders and would greatly reduce their 
interest-rate risk exposure. 

Repealing some of the other benefits of government sponsorship, such as the exemption 
from SEC registration, could also encourage competition from private firms and provide a 
slightly better balance between the benefits received by the GSEs and the benefits passed on to 
the housing finance market. 

It should be stressed that none of these suggestions has received the detailed analysis 
that would be required before a decision can be made on whether or how to adjust government 
sponsorship. 

D. Summary 

The GSEs have made extraordinary contributions in pursuing their public goals. 
Congress has asked whether it is now feasible and desirable to alter or eliminate government 
sponsorship of Fannie Mae and Freddie Mac. 

There seems little doubt that securitization and the secondary mortgage activities 
pioneered by Ginnie Mae, Fannie Mae, and Freddie Mac are now well-established and that the 
secondary market for conforming, conventional mortgages could operate efficiently and 
effectively even if Fannie Mae's and Freddie Mac's government sponsorship were altered. 
However, the broader potential effects of ending that sponsorship remain uncertain. 

For example, the effect of any change upon the GSEs' affordable housing activities is 
unclear. The experience under the housing goals is only a few years old, and it is premature 
to judge how much of the GSEs' activity is driven by Congressional directive and HUD 
oversight and how much by the basic requirement of Fannie Mae and Freddie Mac as 
businesses to generate returns for their stockholders. 

Altering government sponsorship could create the risk of a small increase in mortgage 
rates for the portion of the market in which Fannie Mae and Freddie Mac participate. The 



" For a detailed discussion of user fees, see Congressional Research Service (1996). 

" The pay-as-you-go problem could be mitigated if there were a sunset date for the user fee. 



84 

entry of new competitors into the market could mitigate this effect. Although we have 
analyzed these effects and provided rough estimates, further research would be helpful. 

As Congress considers these matters, we also believe there should be detailed analysis 
of the operation and market implications of the various alternative approaches. A wide range 
of suggestions has been made to reduce the benefits of government sponsorship or to increase 
the public benefits provided by Fannie Mae and Freddie Mac. 

Ending or modifying government sponsorship would entail risk, but would also have 
benefits. The potential effect of privatization on mortgage interest rates or the availability of 
credit for affordable housing represent important risks. Potential benefits could include more 
active competition, more efficient credit allocation, reduced potential risk to taxpayers, and 
reduced government borrowing costs. While preserving the status quo would eliminate any 
uncertainty associated with ending government sponsorship, it has risks as well. 

Fannie Mae and Freddie Mac are important institutions, and no change will occur 
without careful analysis and public discussion. We believe the analysis presented here and the 
additional work suggested can further such discussion. 



85 
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